Profitability Ratios

Profitability reflects the final result of a company’s business operations. Profitability Ratios are also called Income Statement Ratios since most of the items used in their calculations are picked up from the Income Statement. Profit margin ratios and rate of return ratios are the most commonly used profitability ratios. A comparison of profitability ratios with other competitors in the same industry can reveal relative strengths or weaknesses of a business.
Gross Margin RatioGross margin measures the margin remaining after meeting all the manufacturing expenses including labour, material and other manufacturing costs i.e. the costs which are directly related to the business. It also indicates the efficiency of production and pricing strategies of a company. The range of gross margin varies across industries. The service industry will have a higher gross margin ratio compared to the manufacturing industry as they have lower raw material and manufacturing costs. The ratio is calculated as follows: Gross Margin Ratio = (Net Sales – Cost of Goods Sold) / Net SalesGross margin also indicates the amount of cash available to pay the company’s overhead expenses. A company with a higher gross margin can maintain a descent level of profit as long as the overhead costs like rent, utilities, etc. are controlled.Trends of the gross margins over a period of time provide a more meaningful insight into the company's strengths rather than a single years gross margin figure. A company earning a consistently high gross margin over couple of years is in a better position to face a downturn in business. However, a company earning a decent but consistent gross margin is considered to be more stable compared to a company boasting a high but a volatile gross margin. Significant fluctuations in a company's gross margin can be a potential sign of fraud or accounting irregularities.Operating MarginOperating profit margin measures the profitability of a company’s normal and recurring business activities. Operating profits are the profits earned before interest and taxes and extraordinary expenses. It does not include the effect of management’s financing decisions. It indicates the general health of the company’s core business. It is calculated as follows:Operating Profit Margin = (Gross Profit – Operating expenses) / Net SalesNonrecurring and one-time expenses, such as cash paid out in a lawsuit settlement and goodwill write-offs are excluded from the operating margin calculation as they do not represent a company's true operating performance.The operating margin is also considered to be an important measure of management’s efficiency. A company with lower levels of fixed costs tends to have higher operating margins. Lower fixed costs provides management with more flexibility in determining prices. Moreover, healthy a operating margin is important for any business as it provides an additional measure of safety during tough times. Significant increases in operating margin is not necessarily a positive sign. Certain expenses like depreciation are subject to management control and can be manipulated to be seen as an increasing operating margin. Changing the depreciation methods and rates can show a temporary increase in operating margin. EBIDTA marginEBITDA is Earnings before Interest, Tax, Depreciation and Amortization. As mentioned above, management can manipulate the bottom line by changing the depreciation rates. Also, manufacturing companies generally have higher depreciation figure compared to service companies. Financing decisions can alter the effective tax rate paid by a company. These factors make it hard to have a meaningful comparative analysis of a company with its competitors and other industry players. Hence, the EBITDA margin is a good measure for comparing companies across different industries. It is calculated as follows:EBITDA Margin= EBITDA / Net Sales EBITDA can be calculated by adding depreciation figures to the operating margin figure. This ratio is useful while comparing companies which carry large amount of fixed assets subject to heavy depreciation charges such as a mining company or an infrastructure company. It is also useful for comparing companies in a mature industries which are in a consolidation phase. Companies in consolidating industries tend to acquire significant tangible and intangible assets, such as a brands and copyrights, which are subject to large amortization charges.As EBITDA measures the income which is available to pay interest charges, the EBITDA margin very importance to creditors and financial institutions. Companies with higher EBITDA margins are considered to be less financially risky than companies with low levels of EBITDA margins. In practice, the EBITDA margin is used only while analyzing large companies with significant depreciable assets, and for companies with a significant amount of debt financing. Net Profit Margin The net profit margin measures the profit available for distribution amongst shareholders after paying all the expenses during a given period of time. It indicates the efficiency of all business activities conducted during a given period, such as production, administration, selling, financing, pricing, and tax management. It is calculated as follows:Net Profit Margin = Net Profit / Net SalesAnalysis of profit margins along with the study of a company’s cost structure enables an analyst to identify sources of efficiency. Interpreting the trend of net profit should be done along with the study of changes in accounting policies applied by the company.

Return on AssetsReturn on Assets (RoA) measures the efficiency of assets used in a business to generate profits. It is the most widely used ratio when comparing companies in the same industry. The Return on Assets Ratio is calculated as follows: Return on Assets = Net Profit before Tax / Total Assets
A low RoA ratio when compared to the industry average indicates an inefficient use of business assets. However, a high RoA figure does not necessarily indicate that a company is using its assets efficiently. A company carrying highly depreciated and old assets will also have a high RoA figure. Also, since assets are carried at historical values, they remain understated during inflationary periods. Hence, RoA during times of high inflation may be misleading. Companies in industies which employs significant fixed assets (for example, infrastructure companies) tend to have a lower RoAs compared to industries that employ fewer amounts of fixed assets (Technology companies).Return on EquityThis ratio is the most commonly used ratio by equity shareholders to judge the profitability of their funds invested in a firm. Return on Equity (RoE) is calculated as:RoE = (Profit after tax – Preference Dividends paid) / Net WorthNet Worth includes all contributions made by equity shareholders, including paid-up capital, reserves and surplus. You should keep in mind that financing decisions by management affects RoE. For example, assume that companies A and B earn similar operating profits of $100 and have the same tax rate of 30%. Also assume that both the companies have employed capital of $1000. However, company A employs only equity and company B employs debt (at 15% interest rate) and equity in the ratio of 3:7. The following table depicts the difference in RoE of both the companies based on these assumptions. CompanyABPBIT$100$100Interest-$15PBT$100$85Tax (30%)$30$25.5Net Profit$70$59.5Net Profit margin70.00%59.50%Equity employed$1000$700Debt employed-$300Return on Equity 7.00%8.50%In this case, even though both the companies have earned similar operating margins, company B has a higher return on equity (8.50%). This is due to the leverage used by company B. While B provides higher return on equity to shareholders, it is also riskier compared to A which carries no debt. Similarly, RoE is also influenced by the average cost of debt and tax rates.Return on Capital EmployedReturn on Capital Employed (RoCE) indicates the efficiency and profitability of a company's capital investments. It is calculated as:RoCE = Earnings before Interest and Tax / (Total Assets – Current Liabilities)ROCE should always be higher than the rate at which the company borrows, i.e. it should earn more than the cost of funds it applies in the business. The company may face liquidity issues if the interest costs on its debt are more than the return gained on the employed capital.For a company that has fluctuating capital, a more suitable ratio would be Return on Average Capital Employed, which uses the average of opening and closing capital employed during a given period of time.While all the profitability ratios provide valuable insight into a company’s financial performance during the operating cycle, the analyst should be aware of manipulation techniques used for distorting the income statement before drawing any conclusions based upon these profitability ratios.