Profitability Ratio Analysis
You think only by the evolution of turnover and bottom line to know if you are dealing with a good value. The truth is, they don’t give a meaningful indication of a company’s financial health. What is this essential criterion? The answer is profitability. You can measure it in several ways with the profitability ratio analysis.
You need to dig a little deeper into the subject. We told you that there are 3 accounting documents to analyze. Taking into account revenue and bottom line, you haven’t gone a third of the way in your fundamental analysis.
For example, if you want to find good quality stocks on the stock market, you have to think about their sustainability in addition to their profitability.
A little reminder on profitability
You tend to make the mistake of confusing yourself with profitability and profitability. You think it’s the same meaning.
Profitability is how much you make on your bottom line.
Profitability is a measure of the company’s ability to make profits against an investment or its own material resources. For this, there are 4 profitability ratios which are:
Return On Equity: “ROE”,
The return on assets (Return On Assets: “ROA”),
The return on capital employed or invested (Return On Investes Capital: “ROIC”),
Now let’s go into them, trying to get to the point. Then then, which one or which to favor.
ROE and the danger of leverage
It is calculated by the ratio between net income and shareholders’ equity.
ROE = net income / equity
This is the return on investment of the money brought in by shareholders. However, you have to be careful because the leverage is overlooked. It is used to use debt to boost company profits.
For example, if a company raises a loan of 100 million euros at an interest rate of 3% that pays 15%. In the end, it earns 12% more than the cost of borrowed capital and that adds another 12 million euros to the bottom line. How beautiful accounting engineering is.
A high ROE can give you a deceptive illusion of the financial health of the business. Therefore, the majority shareholders will not give gifts to the executives of the company always wanting more profitability. This will encourage the company to resort to more and more debt. In this game, the end result can be disastrous. There are plenty of examples: Enron, Worldcom, Yellow Pages, etc.
If you have stocks of this style in your stock portfolio, beware of the boomerang effect on your performance. You will only have your eyes to cry on.
Return on equity can be subject to manipulation by management because it is one of the financial criteria to determine their financial bonus.
What can you do to avoid getting smoked-up?
You want to be reassured. Favor listed companies that generate a high ROE with a reasonable debt compared to its equity.
What the financial media and professionals won’t tell you is that there are a few pitfalls in equity accounting. Without going into details, take only the equity of the parent group. Then don’t add minority interests because they don’t belong to the parent group.
ROA, a major measure of business efficiency
It is calculated either by the ratio of net income to total assets or by multiplying net margin by asset turnover.
ROA = net income / total assets or Net margin x Asset turnover
ROA is a ratio of profitability that you should not snub in favor of ROE. It makes it possible to measure the effectiveness of the company in generating profits by mobilizing its material and immaterial resources.
Yet many professional and private investors find this financial ratio obsolete. Why ?
Because it has no apparent link with creating shareholder value. Then you will try to comfort yourself with the opinion of Warren Buffett who thinks that this gives no indication of the intrinsic quality of good business, according to the book “Warren Buffett and The Interpretation of Financial Statements” by Mary Buffett and David Clark.
For my part, I admit my preference for this profitability ratio under certain conditions.
First, debt is not included in the calculation. Second, a high ROA is a sign that the company has the leeway to increase its prices and therefore improve its margins. In short, it is excellent for having a healthy idea of your business.
What will annoy you is that this profitability ratio is not reliable for sectors that mobilize a lot of capital such as energy, chemicals, automotive, construction or industrial equipment. But it is for the consumer sector.
During my various participations in general meetings, most of the managers place great emphasis on a profitability ratio that intervenes at the operational level. What we will see in the next chapter.
ROIC, a profitability ratio that deserves to be highlighted
ROIC measures the profitability of the capital invested in the activity of the company without taking into account the financing levers. It can be considered as an indicator of the economic performance of the company and is calculated by the ratio between operating income and capital employed.
ROIC = Operating profit / Capital invested
Of which invested capital = Equity + Net debt or Fixed assets + WCR (Working capital requirement)
Thanks to the capital invested formula, you eliminate financing leverage by deducting debts from short-term cash. You get net debts.
On the asset side of the balance sheet, you have the working capital and fixed assets which correspond to the sum of tangible, intangible and financial fixed assets.
The franchise is essential. On the management side of listed companies, this is a profitability ratio that is often put forward. Why ?
It serves as a benchmark for evaluating the effectiveness of all business divisions but also for deciding the best investment opportunities based on the cost of capital.
But the ROIC does have a few big drawbacks.
You have to be careful about the operating result. It does not include taxes and interest on debt. Depreciations, provisions and depreciation are sometimes underestimated.
It can mask the underperformance of one of the company’s divisions. For example on Apple, the iPad sells but fails to return to its best levels.
For most of you, I am not sure that ROIC is the front line in assessing the profitability of a business. It could represent an alternative to ROE in specific sectors. However, companies in their annual report insist more and more on this profitability ratio still unknown to the general public. They see it as the real creation of shareholder value.
Gross Profit Margin
The gross profit margin calculates the cost of goods sold as a percent of sales—both numbers can be found on the income statement. This ratio looks at how well a company controls the cost of its inventory and the manufacturing of its products and subsequently passes on the costs to its customers. The larger the gross profit margin, the better for the company.
Calculate gross profit margin by first subtracting the cost of goods sold from sales. If sales are $100 and the cost of goods sold is $60, the gross profit is $40. Then divide gross profit by sales which would be: $40 / $100 = 40%. The gross profit margin, which is the amount of sales revenue that can be devoted to utilities, inventory, and manufacturing costs is 40% of sales.
Gross Profit Margin = Gross Profit / Sales
Operating Profit Margin
The operating profit is usually called earnings before interest and taxes or EBIT on a business’s income statement. The operating profit margin is EBIT as a percentage of sales. It is a measure of a company’s overall operating efficiency. It differs from the gross profit margin by further subtracting out the expenses of ordinary, daily business activity from sales.
The operating profit margin is calculated using this formula: EBIT / Sales. If EBIT is $20 and sales are $100, then the operating profit margin is 20%. Both terms of the equation come from the company’s income statement.
Operating Profit Margin = Earning Before Interest and Taxes / Sales
Net Profit Margin
When doing a simple profitability ratio analysis, the net profit margin is the most often margin ratio used. The net profit margin shows how much of each sales dollar remains as net income after all expenses are paid.
For example, if the net profit margin is 5%, that means that 5 cents of every dollar of sales made are profit. The net profit margin measures profitability after consideration of all expenses including taxes, interest, and depreciation.
The calculation is: Net Income / Net Sales =_%.
Both terms of the equation come from the income statement.
Net Profit Margin = Net Income / Sales
Cash Flow Margin
The cash flow margin ratio is an important ratio as it expresses the relationship between cash generated from operations and sales. The company needs cash to pay suppliers, dividends, service debt, and invest in new capital assets, so cash is just as important as profit to a business firm. The Cash Flow Margin ratio measures the ability of a firm to translate sales into cash. The calculation is Cash From Operating Cash Flows / Net Sales = _%. The numerator of the equation comes from the firm’s Statement of Cash Flows. The denominator comes from the Income Statement.
Cash Flow Margin = Cash Flow Operating Cash Flows / Net Sales
Operating Cash Flow Margin
The operating cash flow margin reveals how effectively a company converts sales to cash and is a good indicator of earnings quality.
Operating Cash Flow = Net Income + Non-cash Expenses (Depreciation and Amortization) + Change in Working Capital
Return on Assets
The return on assets ratio is an important profitability ratio because it measures the efficiency with which the company is managing its investment in assets and using them to generate profit. It measures the amount of profit earned relative to the firm’s level of investment in total assets. The return on assets ratio is related to the asset management category of financial ratios.
The calculation for the return on assets ratio is: Net Income / Total Assets = _%. Net income is taken from the income statement, and total assets are taken from the balance sheet. The higher the percentage, the better, because that means the company is doing a good job using its assets to generate sales.
Return on Assets = Net Income / Total Assets
Return on Equity
The return on equity ratio is perhaps the most important of all the financial ratios to a publicly-held company’s investors. It measures the return on the money the investors have put into the company. It is the ratio potential investors look at when deciding whether or not to invest in the company. The calculation is Net Income / Stockholders Equity = _%. Net income comes from the income statement, and stockholder’s equity comes from the balance sheet. In general, the higher the percentage, the better, with some exceptions, as it shows that the company is doing a good job using the investors’ money.
Return on Equity = Net Income / Stockholders Equity
Cash Return on Assets
The cash return on assets ratio is generally used only in more advanced profitability ratio analysis. It is used as a cash comparison to return on assets since the return on assets is stated on an accrual basis. Cash is required for future investments. The calculation is Cash Flow From Operating Activities / Total Assets = _%. The numerator is taken from the Statement of Cash Flows and the denominator from the balance sheet. The higher the percentage, the better.
Cash Return on Assets = Cash Flow From Operating Activities / Total Assets