Financial Ratios On The Assessing Of The Profitability Of A Company
Continued from my last article, we will now look at the financial ratio for assessing the profitability of a company. This type of financial ratio should be able to measure the bottom-line results or the profitability of the company.
Some typical major profitability ratios are:
- Gross profit & Net profit margin,
- Return on Total Assets,
- Return on Equity.
| Ratio | GROSS PROFIT MARGIN |
| Formula | Gross Profit Net Sales |
| Use | Indicates profitability of trading and mark-up |
| Values | Varies. 15-25% for supermarkets #90 % for software industry 20-30% is OK |
| Interpretation | • Must be compared to industry averages and the trend over time • High gross margin means a lot of money left over to spend on other business operations such as research & development or marketing. • If GPM is on downwards trends, might be a tell tale sign of future problems facing the bottom line [when labor and material costs increase rapidly, likely to lower gross profit margins-unless company pass these costs to customers in the form of higher selling prices] • The results may skew if the company has a very large range of products |
| Ratio | NET PROFIT MARGIN |
| Formula | Net Profit After Taxes Net Sales |
| Use | Indicates overall business profitability. Shows how effective managers run the business. |
| Values | Approx 10-20% is good. Higher is better >8% Strong >6% Acceptable <4% Evidence of weakness <2% Weak <0% Problems present |
| Interpretation | • Comparing gross & net margins, we can get a good sense of its non-production & non-direct costs like administration,finance & marketing costs. E.g. in the software business: exceeding high gross margin of #90% but a net profit margin of 27%. This shows that its marketing & administration costs are very high while its cost of sales & operating costs are relatively low. • High net margin means – bigger cushion to protect themselves during hard times & reflects a competitive advantage to improve market share when things improve again. |
| Ratio | RETURN ON TOTAL ASSETS (ROA) |
| Formula | Net Profit After Taxes Total Assets |
| Use | Indicates how well assets are used to create wealth, regardless of capital structure. Profitability of operations management |
| Values | Depends on industry 10-15% is reasonable |
| Interpretation | • Add back interest expenses back into net income when performing this calculation so as to ignore financing and focuses on operations • Affected by assets valuation and mix • Beware of one-off changes • Can be broken into more useful details – asset turnover & profit margin using a Dupont framework. |
| Ratio | RETURN ON EQUITY (ROE) |
| Formula | Net Profit After Taxes Shareholders Equity |
| Use | Indicates how well management is employing the investors’ capital invested in the company. |
| Values | A steadily increasing ROE is a hint that management is giving shareholders more for their money which is represented by shareholders’ equity >30% Strong >20% Acceptable <15% Evidence of weakness <10% Weak < 5% Problems present < 0% Likely to fail |
| Interpretation | • Offers a useful signal of financial success since it might indicate whether the company is growing profits without pouring new equity capital into the business . • Good companies outperform other investments of similar RISK • Return should be higher for higher business and financial risk. |
- Financial Ratios on Assessing The MARKET VALUE Of A Company
- Financial Ratios on Assessing The LEVERAGE or GEARING Of A Company
- Financial Ratio on Assessing The Liquidity Of A Company
- Financial Ratio on Assessing The ACTIVITY Of Assets Utilised
- Ratio Analysis: Which Ratios Have the Most Value?
- Competitive Analysis Using Financial Ratio Analysis
- Ratio Analysis Of A Company
April 5, 2006
Posted in: Ratio Analysis
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