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Why We Love Profitability Ratios (And You Should Too!)

Posted on May 19th, 2018 by The DiscoverCI Team

Simply growing revenues with no control over growing costs is not good enough.

There isn't enough investor money in the world to keep a company operating for long if they aren't able to turn profitable.

This means that part of any good investment strategy needs to focus on ways to measure a company's profitability. 

In this article we’ll cover the important information you need to start using profitability ratios in your financial analysis of a company, including:

  • What profitability ratios are, and what they measure,
  • The different types of profitability ratios,
  • The details around a few specific ratios and why they are important, and
  • provide a list of profitability ratios, with formulas to power your financial ratio analysis.

What are Profitability Ratios and What do they Measure?

Profitability ratios measure a key financial concept that we can all understand - is the company making money, or losing money.

A company could have great products, impressive management, and be well capitalized for future growth, but if they aren’t making money on their products, that company’s future starts looking pretty bleak.

When you are evaluating a stock, you are looking to find companies with strong, improving profits in order to warrant an investment. If you're calculating low ratios while completing your analysis, that could mean the company’s cost structure is out of line with its revenues and they aren’t able to drop revenue to the bottom line.

Just like in personal finance where it doesn’t matter how much money you make if you're spending more than you earn, companies operate in a similar manner.

We want to invest in companies that understand their products, their pricing and are able to manage their expenses!

Analyzing these ratios is a key step in effective financial analysis and fundamental analysis.

Now that we've laid the groundwork, we can start looking at different types of profitability ratios and their formulas.

Types of Profitability Ratios and The Formulas to Calculate Them

There are five main ratios that measure the profitability of a company, which most investors use when they are analyzing a stock.

We’ll start by taking a look at gross profit margin.

Gross Profit Margin

Gross profit margin is calculated by taking a company’s sales, less cost of goods sold, and dividing the total by the company’s sales.

Gross Profit Margin  = (Sales - Cost of Goods Sold) / Sales

Gross profit margin is used to analyze how much money a company makes on each sale of its product, before taking into account the sales, marketing and administrative costs of a company.

For example, Apple Inc’s (AAPL) sales during the fiscal year ended September 30, 2017 was $229,234 (in millions). Apple’s cost of sales was $141,048 leaving $88,186 in gross profit.

The gross profit margin of 38% is calculated by dividing gross profit by total sales.

So what does all that mean?

Cost of sales only reflects the amount of direct expenses it takes for a company to sell a product.

Think of these costs as the raw material and production costs of actually developing the product that was sold.

For an iPhone, this would be the actual hardware costs, the amount Apple paid to employees who assembled the iPhone, and other costs that the Company has determined were directly involved with building the phone (on the flip side, the salary of the employee who sold you the iPhone at the Apple Store would not be included in these costs).

Because the only costs that are included in calculating gross profit margin are the costs required to build/source the product, gross profit margin is intended to show exactly how much money a company makes on sales of their product before taking into account the additional sales, administrative, and marketing expenses it takes to run the company.

For Apple, their gross profit margin is telling us that on every sale of the company’s product, they keep 38% of the money received. The rest of the cash received has already been spent and relates to getting the product ready to sell.

As you can see, the higher the gross profit margin the better!

You want to invest in companies with high gross profit margins because that leaves more money for the company to spend on other activities that are required to grow the business.

If a company has razor thin margins, they aren’t able to invest as much in sales and marketing, or pay for a high powered management team. This can result in slower growth and less return on your investment.

That doesn’t sound like the type of company that would draw your interest!

Alright, let’s press on to a ratio that does take into account some of the costs that gross profit margin doesn’t consider, operating profit margin.

Operating Profit Margin

Operating profit margin is calculated by taking a company’s sales, minus cost of goods sold, minus operating expenses and dividing the sum by the company’s sales.

Operating Profit Margin = (Sales – Cost of Goods Sold – Operating Expenses) / Sales

Operating profit margin expands on gross profit margin, taking it to the next level by including all operating expenses in the measure of a company’s profitability.

Costs included in this ratio that weren’t included in the gross profit margin calculation would be your sales & marketing expenses, accounting fees, legal fees, rent expense at your corporate headquarters, etc…

Pretty much any cost that isn’t directly involved in acquiring or producing the product that the company ultimately sells would fall into this bucket.

Operating profit margin is an important metric to successful businesses, as it paints a more comprehensive picture of a company’s profitability.

A company may have strong gross profit margins, but if they aren’t able to control their back end costs (usually a trait of a weak management team), then that company is going to struggle to generate long-term profitability.

As with gross profit margin, the higher the operating profit margin the better. You want to invest in companies that are able to produce, market and support their products while still retaining as much money on each sale of their product as possible.

Operating profit margin gave us a better picture of a company’s overall profitability, and we’re about to take it one step further. Let’s dive into net profit margin.

Net Profit Margin

We’re cooking with gas now and we’re working our way down a company’s income statement. The financial analysis juices are flowing!

Calculating net profit margin is simply net income divided by sales.

Net Profit Margin = Net Income / Sales

This ratio takes us to the bottom line of a company and tells you how much money a company makes on each sale if you include all of the costs of running a business.

The net profit margin ratio includes costs that aren’t part of the operating profit margin ratio, including non-operating expenses, interest expense, and taxes.

As a smart investor you are looking to invest in businesses and management teams that know how to operate a company efficiently and profitably.

Net profit margin can quickly tell you whether this is the case. If a company has high gross profit margins, but low net profit margins, that should make you wonder…

The company’s cost to develop a product is relatively low, so why aren’t they more profitable? Is the management team doing enough to control the back end costs of running the business? Does this company’s long-term business model make sense?

Maybe not if a company can produce a product at low cost, but actually selling the product and running the business is too expensive!

Following the trend of the ratios before it, you are looking for high net profit margins at the company’s where you invest. This means more profit for the owners, and you my friend would fall into that category.

Boom! We worked our way down the three key ratios that you can calculate by just using the information on a company’s income statement. We’re now jumping into a few ratios that include metrics you can find on the balance sheet as well.

Return on Assets

Return on assets is calculated by taking a company’s net income, adding back interest expense, and dividing that by the company’s average total assets during the period.

Return on Assets = (Net Income + Interest Expense) / Average Total Assets

In order for an asset to be an asset, it needs to be providing positive economic value to a company.

That’s why the costs that a company incurs to buy assets are capitalized on the balance sheet, rather than expensed when the company pays the money. They are expecting to receive a future benefit from the cost!

So how does that apply to the return on assets ratio?

If a company’s return on assets ratio is low, this would indicate that the management team hasn’t effectively invested in the right assets to grow the business, or the company isn’t using their assets as effectively and efficiently as they should.

Either way, it’s not good!

A low return on assets ratio could signal bad news may be coming down the pipeline. If a company’s asset aren’t generating returns at a high percentage, there is likely a dip in earnings on its way. Growing a business and generating income is difficult when you aren’t maximizing your assets!

Return on Equity

Alright, we have arrived at our fifth and final ratio that we’ll be diving into today, return on equity.

Return on equity is calculated by dividing net income by shareholders’ equity.

Return on Equity = Net Income / Shareholders’ Equity

This ratio tells you what the company returns in net income as a percentage of shareholders’ equity.

This is a good way of measuring a businesses profitability by identifying how much profit a company generates with the money invested by shareholders’ and retained in the company.

Usually high growth companies experience a higher return on equity. As a potential investor and shareholder of a company you want to see the high returns on equity.

A high return on equity tells you that when you invest your hard earned cash, the management team will use that money wisely and drive returns for you and the other shareholders.

That translates to higher stock prices and a better return on investment!

And there you have it! Simple, right? We’ve ran through five of the more important profitability ratios, and now it’s time to take a look at a few more ratios that measure profitability.

Complete List of Profitability Ratios and Formulas

We’ve summarized the remaining ratios below (including the ones we covered above), so you have a complete list of ratios and formulas to refer back to when you are knee deep in your analysis:

Profitability Ratio

Formula

Cash Flow Return on Investment Ratio Operating Cash Flow / Capital Employed
Cash Return on Assets Ratio Operating Cash Flow / Average Total Assets
Cash Return on Capital Invested Ratio EBITDA / Invested Capital
Gross Profit Margin Ratio (Sales - Cost of Goods Sold) / Sales
Net Profit Margin Ratio Net Income / Sales
Operating Cash Flow Margin Operating Cash Flow / Sales
Operating Profit Margin Ratio (Sales – Cost of Goods Sold – Operating Expenses) / Sales
Return on Assets Ratio (Net Income + Interest Expense) / Total Assets
Return on Average Assets Ratio (Net Income + Interest Expense) / Average Total Assets
Return on Average Capital Employed EBIT / (Average Total Assets - Average Current Liabilities)
Return on Average Equity Ratio Net Income / Total Shareholders' Equity
Return on Capital Employed Ratio Net Operating Profit / Capital Employed
Return on Equity Ratio Net Income / Shareholders’ Equity
Return on Debt Ratio Net Income / Long-Term Debt
Return on Invested Capital (Net Income - Dividends) / Invested Capital
Return on Investment Ratio (Investment Revenue - Cost Investment) / Cost of Investment
Return on Operating Assets (ROOA) Net Income / Operating Assets
Return on Research Capital Ratio Gross Profit / Previous Year Research & Development Expenditure
Return on Retained Earnings Ratio Net Income / Retained Earnings
Return on Sales Ratio EBIT / Net Sales

These ratios will give you a good idea of a company’s profitability, and measure the company’s profitability against other fundamentals.

Each ratio provides insight in its own way, but generally, the higher the ratio, the more confidence you can have in a company’s ability to deploy resources and continue to be profitable.

The Power of Profitability Ratios in Your Stock Analysis

Profitability ratios are a key piece of the overall fundamental analysis puzzle.

If a company's ratios are low, this could be a signal that the management team is struggling to control costs and deliver a high return to shareholders.

As a group of investors looking for high returns and lower risk, that doesn’t sound like a company that would get your investment!

That was fun!

If you're interested in finding stocks with optimal profitability ratios, check out our article that walks through the process of using a value stock screener to identify investment ideas.

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