Profitability Ratio
Measure the Companies's Operating Effectiveness It can be classified into two categories.
Profit Margin
One category measures profit in relation to sales and reflect the ability of the company’s management to control expenses and turn sales into profit.
Gross profit margin and net profit margin are two ratios frequently used to measure profit against sales.
Gross profit margin formula,
The gross profit margin is affected by the cost of goods sold (and the method for determining the cost), as well as the company’s mark-up on its cost of goods sold.
Net profit margin formula,
Net profit, or net income, is a firm’s income after all expenses, including interest and taxes, have been paid.
The net profit margin is a measure of net profit against net sales. Increasing profit over a period generally means improvement in operating efficiently.
It should be noted that the net profit to sales margin varies widely from industry to industry.
When compared to the average, a company’s profit margin indicates whether the company is operating above or below the average efficiency of other companies in the same industry.
Rate of Return
A second category of profitability ratios measures profitability in relation to the invested fund used to generate these profits.
This profitability ratio is often considered the most revealing measures of the overall effectiveness of the firm’s management.
The operating income rate of return measures the rate of return on total investment before interest and taxes. The total tangible assets figure is used to measure the firm’s total investment.
The formula is,
The total tangible assets of a firm are equal to total assets when there are no intangible assets such as goodwill included in the firm’s assets. If there are intangible assets, the figures for these should be subtracted from the total assets figure to obtain the total tangible assets figure.
Besides, the return on total assets ratio also referred to as return on investment (ROI), measures the rate of return on investment after interest and taxes.
The formula of ROI calculation is,
The operating income rate of return and ROI used to measure earnings against total tangible assets to determine the company’s efficiency in generating income.
However, shareholders would also be interested in net income with respect to the value of shareholders’ equity, which can be calculated from
Return on Equity (ROE)
Return on equity or ROE can be calculated as,
ROE indicates return on investment that the investor is getting from company's profits. Simply put, ROE is stakeholder's return on investment.
For example, stock ABC reported $200 million in profits with 700 million in shareholder's equity at the beginning of financial year, and 900 million shareholder's equity by the end of financial year. It's ROE will be 25 per cent.
Another example, stock XYZ has $800 million shareholder's equity in the beginning of financial year. It bought new equipment worth $300 million as it's investment and make $80 million in profits.
At the same time, it invested the balance amount (another $500 million) in fixed deposit and earn another $20 million. By end of financial year, it gain $100 million in profits with total of $900 million in shareholder's equity. It's ROE will be 11.7 per cent.
In the following year, company XYZ face stiff competition from China that force them to stop business operation for a while. It's management decided to reinvest $900 million in fixed deposit and earned $35 million as interest. It's ROE will be 3.8 per cent.
From above examples, you can easily notice that though the company is making money from shareholder's equity, ROE for stock XYZ was substantially reduced from 11.7 per cent to only 3.8 per cent. If the return is just like you invest in fixed deposit yourself, what for invest in them?
I don't like taking EXTRA risks with no EXTRA return.
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