Profitability Indicator Ratios
We want to take you through the whole process of Profitability Indicator Ratios and below information will clear your doubt that why do people think Profitability Indicator Ratios is a Good Idea?
Profitability Indicator Ratios much like the operational performance ratios, give users a good understanding of how well the company utilized its resources in generating profit and shareholder value. The long-term profitability of a company is vital for both the survivability of the company as well as the benefit received by shareholders. It is these ratios that can give insight into the all- important “profit”.
We look at four important profit margins, which display the amount of profit a company generates on its sales at the different stages of an income statement. We’ll also show you how to calculate the effective tax rate of a company. The last three ratios covered in this section - Return on Assets, Return on Equity and Return on Capital Employed - detail how effective a company is at generating income from its resources.
Profit Margin Analysis
All the amounts in these ratios are found in the income statement. As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net sales, or revenue, of 21,140, which is the denominator in all of the profit margin ratios. The equations give us the percentage profit margins as indicated.
Second, income statements in the multi-step format clearly identify the four profit levels. However, with the single-step format the investor must calculate the gross profit and operating profit margin numbers. To obtain the gross profit amount, simply subtract the cost of sales (cost of goods sold) from net sales/revenues. The operating profit amount is obtained by subtracting the sum of the company’s operating expenses from the gross profit amount. Generally, operating expenses would include such account captions as ‘selling’, ‘marketing and administrative’, ‘research and development’, ‘depreciation and amortization’, ‘rental properties’ etc.
Third, investors need to understand that the absolute numbers in the income statement don’t tell us very much, which is why we must look to margin analysis to discern a company’s true profitability. These ratios help us to keep score, as measured over time, of management’s ability to manage costs and expenses and generate profits. The success, or lack thereof, of this important management function is what determines a company’s profitability. A large growth in sales will do little for a company’s earnings if costs and expenses grow disproportionately. Lastly, the profit margin percentage for all the levels of income can easily be translated into a handy metric used frequently by analysts and often mentioned in investment literature. The ratio’s percentage represents the number of paises there are in each rupee worth of sales. For example, using XYZ’S numbers, in every sales rupee for the company in 2010, there’s roughly 35, 31, and 23 paisa of operating, pre-tax, and net income, respectively.
Let’s look at each of the profit margin ratios individually:
Gross Profit Margin
A company’s cost of sales, or cost of goods sold, represents the expense related to labour, raw materials and manufacturing overhead involved in its production process. This expense is deducted from the company’s net sales/revenue, which results in a company’s first level
Operating Profit Margin
of profit or gross profit. The gross profit margin is used to analyse how efficiently a company is using its raw materials, labour and manufacturing-related fixed assets to generate profits. A higher margin percentage is a favourable profit indicator. Industry characteristics of raw material costs, particularly as these relate to the stability or lack thereof, have a major effect on a company’s gross margin. Generally, management cannot exercise complete control over such costs. Companies without a production process (ex., retailers and service businesses) don’t have a cost of sales exactly. In these instances, the expense is recorded as a “cost of merchandise” and a “cost of services”, respectively. With this type of company, the gross profit margin does not carry the same weight as a producer type company.
Operating Profit Margin
By subtracting selling, general and administrative, or operating expenses from a company’s gross profit number, we get operating income. Management has much more control over operating expenses than its cost of sales outlays. Thus, investors need to scrutinize the operating profit margin carefully. Positive and negative trends in this ratio are, for the most part, directly attributable to management decisions. A company’s operating income figure is often the preferred metric (deemed to be more reliable) of investment analysts, versus its net income figure, for making inter-company comparisons and financial projections.
Pre-tax Profit Margin
Again, many investment analysts prefer to use a pre-tax income number for reasons similar to those mentioned for operating income. In this case a company has access to a variety of tax-management techniques, which allow it to manipulate the timing and magnitude of its taxable income.
Net Profit Margin
Often referred to simply as a company’s profit margin, the so-called bottom line is the most often mentioned when discussing a company’s profitability. While undeniably an important number, investors can easily see from a complete profit margin analysis that there are several income and expense operating elements in an income statement that determine a net profit margin. It behoves investors to take a comprehensive look at a company’s profit margins on a systematic basis.
Effective Tax Rate
This ratio is a measurement of a company’s tax rate, which is calculated by comparing its income tax expense to its pre-tax income. This amount will often differ from the company’s stated jurisdictional rate due to many accounting factors, including foreign exchange provisions. This effective tax rate gives a good understanding of the tax rate the company faces.
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had a provision for income taxes in its income statement of 1,717 (income statement) and pre-tax income of 7,520 (income statement). By dividing, the equation gives us an effective tax rate of 23% for FY 2010.
The variances in this percentage can have a material effect on the net-income figure. Peer company comparisons of net profit margins can be problematic as a result of the impact of the effective tax rate on net profit margins. The same can be said of year-over-year comparisons for the same company. This circumstance is one of the reasons some financial analysts prefer to use the operating or pre-tax profit figures instead of the net profit number for profitability ratio calculation purposes.
One could argue that any event that improves a company’s net profit margin is a good one. However, from a quality of earnings perspective, tax management manoeuvrings (though may be legitimate) are less desirable than straight-forward positive operational results.
Tax provision volatility of a company’s finances makes an objective judgment of its true or operational net profit performance difficult to determine. Techniques to lessen the tax burden are practiced, to one degree or another, by many companies. Nevertheless, a relatively stable effective tax rate percentage and resulting net profit margin, would seem to indicate that the company’s operational managers are more responsible for a company’s profitability than the company’s tax accountants.
Return On Assets
This ratio indicates how profitable a company is relative to its total assets. The return on assets (ROA) ratio illustrates how well management is employing the company’s total assets to make a profit. The higher the return, the more efficient management is in utilizing its asset base. The ROA ratio is calculated by comparing net income to average total assets, and is expressed as a percentage.
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net income of 5,803 (income statement), and average total assets of 19,922 (balance sheet). By dividing, the equation gives us an ROA of 29% for FY 2010.
The need for investment in current and non- current assets varies greatly among companies. Capital-intensive businesses (with a large investment in fixed assets) are going to be more asset heavy than technology or service businesses. In the case of capital-intensive businesses, which have to carry a relatively large asset base, will calculate their ROA based on a large number in the denominator of this ratio. Conversely, non-capital-intensive businesses (with a small investment in fixed assets) will be generally favoured with a relatively high ROA because of a low denominator number.
The need for investment in current and non- current assets varies greatly among companies. Capital-intensive businesses (with a large investment in fixed assets) are going to be more asset heavy than technology or service businesses. In the case of capital-intensive businesses, which have to carry a relatively large asset base, will calculate their ROA based on a large number in the denominator of this ratio. Conversely, non-capital-intensive businesses (with a small investment in fixed assets) will be generally favoured with a relatively high ROA because of a low denominator number.
It is precisely because businesses require different-sized asset bases that investors need to think about how they use the ROA ratio. For the most part, the ROA measurement should be used historically for the company being analysed. If peer company comparisons are made, it is imperative that the companies being reviewed are similar in product line and business type. Simply being categorised in the same industry will not automatically make a company comparable. As a rule of thumb, investment professionals like to see a company’s ROA come in at no less than 5%. Of course, there are exceptions to this rule. An important one would apply to banks, which typically have a lower ROA.
Return On Equity
This ratio indicates how profitable a company is by comparing its net income to its average shareholders’ equity. The return on equity ratio (ROE) measures how much the shareholders earned for their investment in the company. The higher the ratio percentage, the more efficient management is in utilizing its equity base and the better return is to investors.
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net income of 4,845 (income statement), and average shareholders’ equity of 19,922 (balance sheet). By dividing, the equation gives us an ROE of 24.3% for FY 2010. XYZ on account of being a debt free company has its ROE equal to ROA. If a company has issued preferred stock, investors wishing to see the return on just common equity may modify the formula by subtracting the preferred dividends, which are not paid to common shareholders, from net income and reducing shareholders’ equity by the outstanding amount of preferred equity.
Widely used by investors, the ROE ratio is an important measure of a company’s earnings performance. The ROE tells common shareholders how effectively their money is being employed. Company peers and industry and overall market comparisons are appropriate; however, it should be recognized that there are variations in ROEs among some types of businesses. In general, financial analysts consider return on equity ratios in the 15-20% range as representing attractive levels of investment quality.
While highly regarded as a profitability indicator, the ROE metric does have a recognized weakness. Investors need to be aware that a disproportionate amount of debt in a company’s capital structure would translate into a smaller equity base. Thus, a small amount of net income (the numerator) could still produce a high ROE off a modest equity base (the denominator).
For example, let’s reconfigure XYZ’S debt and equity numbers to illustrate this circumstance. If we reduce the company’s equity amount by Rs. 9,922 crores and increase its long-term debt by a corresponding amount, the reconfigured debt-equity relationship will be (figures in Rs. crores) 9,922 and 10,000, respectively. XYZ’S financial position is obviously much more highly leveraged, i.e., carrying a lot more debt.
However, its ROE would now register a whopping 58% (5,803 ÷ 10,000), which is quite an improvement over the 29% ROE of the almost debt-free FY 2010 position of XYZ indicated above. Of course, that improvement in XYZ’S profitability, as measured by its ROE, comes with a price...a lot more debt and thus a lot more risk.
However, its ROE would now register a whopping 58% (5,803 ÷ 10,000), which is quite an improvement over the 29% ROE of the almost debt-free FY 2010 position of XYZ indicated above. Of course, that improvement in XYZ’S profitability, as measured by its ROE, comes with a price...a lot more debt and thus a lot more risk.
The lesson here for investors is that they cannot look at a company’s return on equity in isolation. A high or low ROE needs to be interpreted in the context of a company’s debt-equity relationship. The answer to this analytical dilemma can be found by using the return on capital employed (ROCE) ratio.
Return On Capital Employed
The return on capital employed (ROCE) ratio, expressed as a percentage, complements the return on equity (ROE) ratio by adding a company’s debt liabilities, or funded debt, to equity to reflect a company’s total “capital employed”. This measure narrows the focus to gain a better understanding of a company’s ability to generate returns from its available capital base.
By comparing net income to the sum of a company’s debt and equity capital, investors can get a clear picture of how the use of leverage impacts a company’s profitability. Financial analysts consider the ROCE measurement to be a more comprehensive profitability indicator because it gauges management’s ability to generate earnings from a company’s total pool of capital.
By comparing net income to the sum of a company’s debt and equity capital, investors can get a clear picture of how the use of leverage impacts a company’s profitability. Financial analysts consider the ROCE measurement to be a more comprehensive profitability indicator because it gauges management’s ability to generate earnings from a company’s total pool of capital.
As of March 31, 2010, with amounts expressed in Rs. crores, XYZ had net income of 5,803 (income statement). The company’s average short-term and long-term borrowings were 0 and the average shareholders’ equity was 19,922 (all the necessary figures are in the 2009 and 2010 balance sheets), the sum of which, 19,922, is the capital employed. By dividing, the equation gives us an ROCE of 29% for FY 2010.
Often, financial analysts will use operating income (earnings before interest and taxes or EBIT) as the numerator. There are various takes on what should constitute the debt element in the ROCE equation, which can be quite confusing.
Our suggestion is to stick with debt liabilities that represent interest-bearing, documented credit obligations (short-term borrowings, current portion of long-term debt, and long-term debt) as the debt capital in the formula.
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