Profitability of companies is
very important and managers try to use as wise as possible the firm’s assets in
order to have increased productivity and reduce costs.
Before putting forward the
ratios that deal with profitability, it is wise to clarify two terms: solvency
and liquidity. They both refer to the company’s state of financial health and
its ability to meet long term financial obligations. Liquidity refers to the
firm’s ability to pay short term liabilities, or the ability to raise cash by
selling assets (we said about the order of assets being listed on the balance
sheet).
Solvency refers to the
ability of the company to meet its long term obligations. A solvent company
then is one that owns more than it owes, thus it has a positive net worth (assets
– liabilities).
Gross profit margin shows how
effectively management uses material and labor in the production process.
Gross profit margin = sales – COS/sales, where COS is cost
of goods sold
When labor and material cost
rise they are likely to lower gross profit margin, or the company will be
forced to pass it on the customers. In order to determine if these costs are in
or out of line, is to compare the gross profit margin with other comparable
companies.
Operating profit margin shows
how successful has the company been in generating income from the business
operations.
Operating profit margin = EBIT/ sales where EBIT is Earning before interest and
taxes
EBIT is earnings after
deducting cost of goods sold and operating expenses from sales. Thus an
operating profit margin of say 10%, indicates how much EBIT is generated per
(dollar, euro) of sales. A high operating profit margin indicates that sales
are faster than operating costs.
Net profit margin is that
generated from all phases of the business.
Net profit margin = net profit/sales
The level of net profit
margin varies from industry to industry.
The return on equity measures
the rate of return to stockholders. The higher the return the more attractive
is the company’s stock.
Return on equity = net profit/net worth net
worth is assets – liabilities, or stockholders’ equity
The return on investment
(ROI) was developed by the Du Pont Company for its own use, but then grew to be
used by many companies as a convenient way to measure the combined effects of
profit margins and total asset turnover. The purpose of the formula is to
compare the way the firm generates profits, and the way it uses its assets to
generate sales. If assets are used effectively income and ROI, will be high.
ROI = net income/sales * sales/total
assets = Net income/ Total assets
notice that sales cancel each other from numerator and denominator.
There are also ratios called
market ratios and are used mainly by investors and how the company’s stock is
performing. Such ratios are the price to earnings ratio, P/E, the dividend
yield and the payout ratio. The P/E ratio is a price multiple of earnings and
what investors are willing to pay for the price of stock (a multiple of
earnings).
The dividend yield is a financial
ratio that indicates how much a company pays out in dividends relative to its
share price. The payout ratio is a fraction of net income the firm pays out its
stockholders in dividends.
