Blog #02 - Profitability Ratios

 

Profitability Ratios

As discussed in Blog #01 Profitability ratios tell us how good a company is at making money. As name is simple it tells the profit of a company and position of company in market competition while comparing it other company of same sector. Profitability ratios are calculated from income statements, sources of income and expenses. All these deciding parameters are declared in company’s results quarterly or yearly. The most common ratio of profitability ratio is profit margin. Profit margin is calculated by dividing the “Net Profit” by “Sales Revenue”. i.e. Profit Margin = (Net Profit / Sales Revenue), from here one can conclude that if profit margin is good then the company is also good means it follows direct relation.

Whenever we talk about profitability ratio, two types of returns come into play i.e. return on sales and return on investment. Let discuss about each in details.

Return on sales: Return on Sales deals with percentage of return that we get as profit on sales. It has mainly four metrics namely:

#1 Gross Profit Margin

#2 Operating Profit Margin

#3 Pretax Margins

#4 Net Profit Margins 

 

 

Return on investment: Return on investment deals with how much profit you get on the employed capital (it may be your money, loan or anything)

#1 Return on Assets (RoA).

#2 Operating RoA.

#3 Return on Total Capital (debt and equity included).

#4 Return on Equity.

#5 Return on common equity (RoCE) – for outstanding shares of a listed company.

Here we will focus mainly on return on sales and return on investment will be explored in next blog.

Let take an example of a car manufacturing company whose income statement (for a year) is given as:

Revenue = 200,00,000

Cost of Goods Sold (COGS) = 800000 (material and labor charges).

Gross Profit = 1,20,00000 (Revenue – COGS)

Marketing & Sales =  20,00,000

Office & Administration =10,00,000

EBITDA = 90,00,000 (Earnings Before Interest Taxes Depreciation & Amortization)

Depreciation = 1000000

Amortization = 0

EBIT = 80,00,000 (EBITDA – (Depreciation + Amortization))

Here we will consider EBIT as Operating Profit because other incomes are not included if other incomes (like interest or rental incomes) were present then you have to subtract them.

Interest                                    : 20,00,000

PBT (Profit Before Tax)               : 60,00,000

Tax @30% (say)                         : 18,00,000

Net Profit                                  : 42,00,000

Let calculate our margins.

Gross Profit Margin       

Gross Profit Margin is ratio of Gross profit to Net Sales. In our case it will be      Gross profit/Revenue i.e. 12000000/20000000 = 0.6 which means you have 60%  Gross Profit Margin.

Operating Profit Margin

Operating Profit Margin is ratio of operating profit to net sales. In our case EBIT is operating profit so OPM will be 80,00000/20000000 = 0.4 which means you have 40% of profit margin.

Pretax Margin

Pretax Margin is calculated by dividing PBT (Profit Before Tax) by Net Sales. In our case it will be 6000000/20000000 which is approximate equal to 0.3. This means we have 30% of Pretax margin.

Net Profit Margin 

Net Profit Margin is defined as the ratio of net profit to net sales. In our case it will be 4200000/20000000 that is equal to 0.21 means we have 21% of net profit margins. 

 

Now the question arises why we calculate these ratios?

Gross Profit Margin

If we are comparing two companies then it is naturally that we will look for higher gross profit margin. How will you get higher gross profit margins? Higher gross profit margins mainly depend on higher pricing or Lower Cost. Let see how?

 

Higher Pricing means company will get competitive advantage. It may have superior product, superior branding or exclusive technology. On the other hand lower cost will contribute as economies of scale (mass production of low cost items) and operational efficiencies. The factors, higher pricing and lower pricing will lead to higher gross profit margin. 

 

Operating Profit Margin

What are the things that operating profit margin will tell different from GPM? During the calculation we noticed some terminologies like marketing & sales, office & admin, depreciation and amortization called operating costs which are extra and they will tell that if operating margins are increases and gross profit margin is same means company has good control over operating costs like admin and if operating profit margin is less than GPM growth it means company has not control over operating cost or management is not so efficient to manage this. So mainly we get information about operating cost of a company from this ratio.

Profit Before Interest (PBT)

PBT is operating profit – interest. In our case suppose if tax would be 40,00000 instead of 20,00000 then pretax margin will be reduced. Generally pretax margins reflect effect of debt (interest) on margins.

Net Profit Margin

In net profit margin all operating and non operating expenses get deducted in net profit. This ratio gives overall picture of a company’s profitability. Whenever an investor or firm goes for investment in any company it should go through all the margins discussed above. Generally all investors take decisions on the basis of net profit margin but it is wrong because it doesn’t tell the truth about a company so all the margin should be examined before investing.