In a previous article, I discussed the concept of operating performance for companies, specifically relating to ratios that measure the efficiency of a company’s use of its assets. In part two of this brief series, I want to look at the second half of what constitutes operating performance: profitability. For a company to be successful, it needs to not only deploy its capital efficiently, it also needs to make good returns for investors. Here are a number of ratios that analysts typically use when trying to assess profitability.
Gross profit margin
This is calculated by taking gross profit and dividing it by total sales. Gross profit is simply sales minus the cost of goods sold (COGS). COGS refers to the cost of materials and labor used to create the company’s products, including paychecks and the cost of basic materials like steel and so on.
Gross profit margin is, therefore, a measure of how good the company is at keeping its cost of goods sold down. It is measured as a percentage, and a higher percentage indicates that a company is making a more profit per sale.
Operating profit margin
This is similar to gross profit margin, and appears one line down the income statement. Operating profit margin is calculated by taking operating profit and dividing it by sales. Operating profit (sometimes called earnings before taxes, or EBIT) is simply gross profit minus expenses.
A company’s expenses include the rent that it pays for office space, advertising costs, depreciation, salespeople salaries and so on. In this way, operating profit margin also provides a measure of whether the company is good at controlling costs. Analysts can then compare gross and operating profit margins to see whether COGS or expenses affect the margin more.
This can tell you a lot about what specific challenges the business is facing. For instance, a company making a cheap product that is not different to its competition may have a very low cost of goods sold (and therefore high gross profit margin), but has to spend a lot on advertising to convince customers that theirs is the superior product, lowering their operating profit margin as a result.
Net profit margin
This is net income divided by sales. Net income is just earnings after tax and interest - the money that is left over for shareholders after all is said and done. A business with a high debt load may have good gross and operating profit margins, but lose a lot of money servicing its interest payments. The net profit margin accounts for this and provides the analyst with a final margin number that takes all costs and expenses into account.
Return on assets
Calculated by taking net income and dividing it by average total assets. It is somewhat similar to the total and fixed asset turnover ratios that we looked at in the previous article, except instead of looking at the top-line (sales), return on assets looks at the bottom like (net income). As such, it is partly an efficiency metric as well as a profitability metric.
Return on equity
This ratio is calculated by taking net income and dividing it by average total equity. As with ROA, return on equity looks at how well the business is using something (in this case, equity) to generate profits. ROE is sometimes preferred to ROA for two reasons. For one, equity represents owner interest in a business, and as an investor/analyst that is what you should primarily be interested in. Secondly, ROE allows more apples to oranges comparisons than ROA, as businesses in different industries tend to have very different types of asset bases.
Read more here:
- How to Analyze a Company's Operating Performance: Efficiency Ratios
- Should Berkshire Hathaway Analyze the Moats of Technology Companies
- How to Measure a Company's Liquidity
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