Accountancy Notes

What Can I Learn from Profitability Ratios?

The profitability ratios include: operating profit margin, net profit margin, return on assets and return on equity.

Profit margin measures how much a company earns relative to its sales. A company with a higher profit margin than its competitor is more efficient. There are two profit margin ratios: operating profit margin and net profit margin. Operating profit margin measures the earnings before interest and taxes, and is calculated as follows:

Gross Profit Margin =

Profits Before Interest and Taxes

Sales

Net profit margin measures earnings after taxes and is calculated as follows:

Net Profit Margin =

Profits After Taxes

Sales

When asked for a ratio you simply put either gross or net profit x100 over the total sales.

While it seems as if these both measure the same numbers, their results can be dramatically different due to the impact of interest and tax expenses. Similarly, the next two ratios appear to be similar but they tell different stories. As an investor, banker or any other interested stakeholder, you are interested in getting a return on your investment. So are a company and its shareholders!

Return on capital employed (ROCE)) tells how well management is performing on all the firm’s resources. However, it does not tell how well they are performing for the shareholders. It is calculated as follows:

Return on Capital employed

Net profit before Taxes and interest

Total Capital Employed

These ratios are easy to calculate and the information is readily available in a company’s annual report.

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When Is an Increase in Earnings a Loss?

Sometimes an increase in company earnings can disguise an operating loss. If a company’s operating expenses exceed its operating income; it has an operating loss. If it also has income from investments and tax benefits, this income can offset the loss and show an increase in earnings per share. However, if these other sources of non-operating income are not recurring, the unsuspecting investor may come to the wrong conclusion about the company’s overall financial health.

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How to Use Profitability Ratios to Make Investment Decisions

When considering a company as a prospective investment you should review its financial statements. Pay particular attention to the profitability ratios. If you can, calculate the ratios for the same company over several successive years to see if the company earnings are consistent, growing, or declining.

Compare your candidate’s ratios to other companies in the same industry. This will help you determine where your candidate stands in the industry.

Do not ignore other financial information on the profit and loss statement and balance sheet. Pay particular attention to losses in income items.

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Price to Earnings Ratio (P/E)

The price to earnings ratio, or P/E, is figured by dividing the stock price by the company’s earnings per share (EPS). The P/E is a performance benchmark that can be used as a comparison against other companies or within the stock’s own historical performance. For instance, if a stock has historically run at a P/E of 35 and the current P/E is 12, you will want to explore the reasons for the drastic change. If you believe that the ratio is too low, you may want to buy the stock.

You will generally find a P/E ratio based on either the prior reporting year’s earnings, or the earnings of the prior four quarters added together. This latter number is referred to as LTM or Latest Twelve Months. While this is useful for understanding the history of a company, most analysts prefer to view a forward-looking P/E ratio. This ratio is calculated by dividing the stock price by the analysts’ earnings estimate for the next year or two.

One other note on P/E Ratios – sometimes, when a company is not doing well, it will buy back shares so that the EPS and P/E Ratio will appear better. This can be seen in the example below.

Example 1

Example 2

Net Income

£1,000,000

£1,000,000

Shares Outstanding

10,000,000

8,000,000

Earnings Per Share (EPS)

£0.10

£0.125

Stock Price

£3.00

£3.00

P/E Ratio

30

24

In the table above, the only change from Example 1 to Example 2 is in the number of shares outstanding. The net income and stock price remain the same. However, by changing the shares outstanding, the EPS has changed quite a bit. This means that the P/E ratio has also changed. At first glance, if a stock’s EPS has increased 25% and its P/E ratio has gone from 30 to 24 it might look like a better buy. However, the truth is that nothing has changed but the number of shares. The stock is not a better buy in Example 2 than it was in Example 1.

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Current Ratio

The current ratio provides an indication of how liquid a company may be in the coming year. To calculate it, take the current assets and divide that number by the current liabilities. You will find all of these figures on the balance sheet.

An answer of 1.0 or better is generally considered good. However this, like other ratios, can depend on a company’s current stage of growth. A start-up company should have a lower ratio than an established company. If it does not, then you will want to ask yourself why and do further research.

A current ratio can also be affected by how much long-term debt a company has in relation to its short-term debt. Some companies prefer to use short-term debt and reissue it more often. Other companies minimise their use of short-term debt. Most companies use a mix depending on what is available to them, what is cheaper at the moment and how their economists project interest rates for the future. Hence, this ratio also needs to be used to build a bigger picture rather than in isolation.

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Long-term Debt to Equity

The long-term debt to equity ratio can tell you how much debt a company is using to finance its operations. If this number is too high it may signify future liquidity problems. If this number is too low it can signify inefficient use of the financing alternatives available to a company.

This ratio is calculated by taking the long-term debt of a company and dividing it by the shareholders’ equity. Be sure to include the company’s lease obligations (which can be found in detail in the footnotes of an annual report) when calculating long-term debt.

Start up companies which have access to the debt markets, often have higher ratios than more established companies. In addition, the amount of debt a company can safely issue varies by industry. For example, companies with large manufacturing facilities often have more long-term debt than companies that provide services or software. Therefore, it is useful to look at the ratios of numerous companies in the same industry before drawing any conclusions.

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Total Debt to Equity

Since companies can affect either the current ratio or the long-term debt to equity ratio by altering their mix of short-term and long-term debt, this ratio can often be more useful than the other two. This ratio is calculated by dividing all long-term debt, short-term debt and lease obligations by the shareholders’ equity.

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Why will a business prefer to declare a high gross profit margin?

A business will want to declare a high gross margin as it will mean that the gap between its costs and revenues/prices remains healthy. This should allow it to absorb business expenses and still have sufficient money over to invest, pay tax and reward shareholders with a dividend. However, always look at trends, compare like with like and note that some industries work on smaller margins than others.

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What should the ROCE figure be compared with when analysing a company’s results?

They should be looked at against previous years results, the results of major rivals, the current rates of interest and returns on alternative investments and any national averages that might be available.

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Explain the relevance to a company of declaring a net profit margin that is not a great deal lower that its gross margin.

This ratio measures the relationship between the net profit declared and the sales or turnover of the company. If is quite close to the gross margin ration outcome then the company is keeping a tight hold on business costs and is working efficiently. Once again this should allow it to meet both its external requirements and satisfy shareholder demands for dividends.

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