Section: 2 Financial Ratio Analysis

Sub Section: 2 Profitability Ratios

Profitability is an indicator of success in business. Measurement of profitability is the main concern for all interested parties, i.e. creditors, investors, owners and management. Net sales are taken as a denominator in calculating all the ratios for return.  Gross profit margin, operating profit margin and net profit margin represent the company’s ability to translate sales into profit at different stages of measurement. 

 

Gross Profit Margin(%)

This is one of the most important ratios to measure the profitability of a company. This ratio gives the relationship between total sales and cost of sales. Gross margin is calculated by subtracting cost of sales from net sales.  The resultant gross profit is then divided by sales to arrive at gross margin ratio.  This ratio indicates margin available to absorb selling and administrative costs and other expense and losses to arrive at net profit.

 

 

The magnitude of gross margin is largely industry specific. Interpretation of gross margin needs reference to industry norm.

 

Operating Profit Margin(%)

Operating profit is another useful indicator of profitability resulting purely from the core operations of the business. This ratio establishes the relationship between operational profit and sales. The return from core operations before non operational expenses, revenues and taxation shows the profit generating ability of the firm from its main business. 

 

 

The formula for operating profit margin is:

 

 

Net Profit Margin(%)

This is the relationship between net profit and sales. Calculation of this ratio can be modified depending on the analyst need, such as net profit can be replaced by earning before interest expense or earning after interest and taxes.  Analysts must look for any unusual or non-recurring income/expenses or gain/loss that relates directly to the core operations of the business.  These items must be excluded while measuring the “pure effectiveness” of the business.

 

Net margin is computed using the following equation:

 

 

Return on Assets/Investment (ROA/ROI)(%)

This ratio measures the overall effectiveness of the business in generating profit with the given investment/assets. The higher this ratio, the greater the profitability. This ratio is an indicator of overall profitability of the business with both equity and debt capital. Investors are keen to look at this ratio as it provides an overall picture of the business profitability.    

 

The equation for ROI calculation:

 

 

Return on Equity (ROE)(%)

Measures the return earned by the business on the owners capital or equity capital. This ratio plays a vital role in the equity holders’ investment decisions. Owners would like to see this ratio going up. ROE is computed adopting the formula given below:

 

 

The Dupont Analysis

The importance of ROE as an indicator of performance, makes it desirable to divide the ratio into several components that provide insight into the causes of the firms ROE or any change in it. This breakdown of ROE into component ratios is generally referred to as DuPont system. To begin, the return on equity (ROE) ratio can be broken down into two ratios – net profit margin and equity turnover:

 

 

This reveals that ROE equals the net profit margin times the equity turnover, which implies that a firm can improve its return on equity by either using its equity more efficiently or becoming more profitable.

 

A firm’s equity turnover is affected by its capital structure. Specifically, a firm  can increase its equity turnover by employing a higher proportion of debt capital. We can see this effect by considering the following relationship:

 

 

This equation indicates that the equity turnover ratio equals the firm’s total asset turnover times the ratio of total assets to equity, a measure of financial leverage. This break down in  equity turnover ratio implies that a firm can increase its equity turnover either by increasing its total assets turn over or by increasing its financial leverage ratio.

 

Combining these two breakdowns, we see that a firm’s ROE is composed of three ratios (DuPont System) as follows:

 

 

 

Operating Expense Analysis

This analysis is done by management to assess the effectiveness of expenses incurred in generating sales. Operating expenses are expressed as a percentage of sales to identify what percentage of sales is spent on a particular overhead. For example, marketing and promotion expenses can be expressed as a percentage of turnover; this ratio can give some guidelines to compare the effectiveness of marketing expenses in generating sales over a given period of time:

 

• Click here to Bookmark lblClickheretounbookmark
• |
• Test Quiz