Key Financial Ratios – Profitability

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There are a number of key financial ratios that can be used to assess a firm’s performance, competitiveness and ability borrow and pay debt. These key financial ratios cover a broad range of performance indicators including: (1) Profitability, (2) Asset Productivity, (3) Liquidity, (4) Solvency / Financial Leverage and (5) Market Value. This tutorial is the first of 5 on key financial ratios. Profitability is covered in this first one. 

 

Utilizing these ratios requires the financial statements of the firm you’re looking to assess. It is highly recommended that this exercise be done for the firm’s competitors within the industry as well so that a relative comparison can be made since there are no universal thresholds for an “optimal” ratio.

Let’s start by looking at the ratios that most people are drawn to simply by the word and what it describes:

Key Financial Ratios :  PROFITABILITY

1. Gross Profit Margin
Definition : Profit margin expressed as a percentage of Net Sales, where Gross Profit is equal to Net Sales less COGS (cost of goods sold)
Notes: As the Gross Profit increases, the greater the ability to cover overhead expenses (Selling, General & Admin Expenses) and be profitable
Financial Statement(s) Needed : Income Statement
Formula: Gross Profit ($) = Net Sales – Cost of Goods Sold                                                                       Gross Profit Margin (%) = Gross Profit / Sales
Example :
Net Sales = $1,000; Cost of Goods Sold = $550;
SG&A expenses = $250; Other income/(expense), net = ($150)
Gross Profit ($) = $1,000 – $550 = $450
Gross Profit Margin = $450 / $1,000 = 45%
Other Notes: This key financial ratio is based on an accurate calculation of Cost of Goods Sold (COGS). Inventory valuation method chosen can have an impact on Gross Profit Margin

 

2. Operating Profit Margin
Definition : Operating Profit expressed as a % of Net Sales, where Operating Profit is equal to Gross Profit less Operating Expenses like Selling, General & Administrative Expenses.
Notes: This margin represents profitability after covering overhead expenses. Being unprofitable or experiencing a loss at the operating margin level means that Gross Profit is not enough to cover overhead expenses. Starting at the top, evaluate things like product returns and cost of goods sold. If those figures are acceptable, then tackling overhead is your next best option.
Financial Statement(s) Needed : Income Statement
Formula: Operating Profit ($) = Gross Profit – Operating Expenses                                                             Operating Profit Margin (%) = Operating Profit ($) / Net Sales
Example :
Sales = $1,000; Cost of Goods Sold $550;
Operating Expenses = $250; Other income/(expense), net = ($150)
Operating Profit = ($1,000 – $550 ) – $250 = $200
Operating Profit Margin = $200 / $1,000 = 20%
Other Notes: This ratio, in comparison to the other profitability ratios,  is considered to be the most accurate measurement of profitability.

 

3. Net Profit Margin
Definition : Net Profit expressed as % of Net Sales, where Net Profit is equal to Operating Profit less Other Income & Expenses.
Notes: Net Profit represents profit that remains after covering all expenses. If operating profit margin is a positive figure, then “other” expenses are not enough to allow profitability.
Financial Statement(s) Needed : Income Statement
Formula: Net Profit ($) = Operating Profit  - Net Other Income & Expenses                                                         Net Profit Margin (%) = Net Profit ($) / Net Sales
Example :
Sales = $1,000; Cost of Goods Sold $550;
Operating Expenses = $250; Other income/(expense), net = ($150)
Net Profit = (($1,000 – $550 ) – $250) – $150 = $50
Net Profit Margin = $50 / $1,000 = 5%
Other Notes: Note that this ratio in itself doesn’t represent the “true” bottom line. Things like the effects of changes in accounting policy, extraordinary gains and losses, foreign currency translation and discontinued operations have to be taken in to consideration to get a picture of the “true” bottom line.
4. Earnings Per Share (EPS)
Definition : Measure of Net Income on a per share basis.
Notes: When EPS increases, it’s a good sign. It means the firm is experiencing growth and profitability. By the same token, a decrease in EPS signals weak performance. Compare to other players in the industry for comparison.
Financial Statement(s) Needed : Income Statement & Balance Sheet
Formula: Earnings Per Share (EPS) = [Net Income - Preferred Dividends] / # of Common Shares Outstanding
Example :
Net Income = $100,000; Preferred Stock Dividends = $10,000
Common Shares Outstanding = 30,000
Market Price of Stock = $50
Earnings Per Share = ($100,000 – $10,000) / 30,000 = $3
Other Notes: Companies often buy back their own stock. When this happens, total common shares outstanding is reduced. Lowering the common shares outstanding will yield a higher Earnings Per Share. It’s a good idea to read annual reports to see share buy backs have had material impact on EPS.

 

5. Price To Earnings Ratio (P/E)
Definition : Represented as a multiple, measuring the number of times the stock price is trading over the company’s earnings.
Notes: A high P/E ratio indicates positive reaction from investors. It could also mean the stock price is over valued. A low P/E ratio indicates negative reaction from investors. It could also mean that the market has yet to react to the stock
Financial Statement(s) Needed : Income Statement & Balance Sheet + Market Price of Stock
Formula: Price To Earnings Ratio = Market Price of Stock / Earnings Per Share (EPS)
Example :
Net Income = $100,000; Preferred Stock Dividends = $10,000
Common Shares Outstanding = 30,000
Market Price of Stock = $50; Earnings Per Share = ($100,000 – $10,000) / 30,000 = $3
Price To Earnings Ratio = $50/$3 = 16.67x
Other Notes: As with the EPS ratio, look to see if stock buy back from the company has had a material impact on Earnings Per Share, which affects the P/E Ratio

 

 

Read About Other Key Financial Ratios:

Key Financial Ratios – Asset Productivity

Key Financial Ratios –  Liquidity

Key Financial Ratios – Solvency / Financial Leverage

Key Financial Ratios – Market Value

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