Profitability Ratios
List the profitability ratios.
(Gross) Profit Margin Return on Assets (ROA) Return on Equity (ROE)
How is the (gross) profit margin calculated?
(Gross) Profit Margin (%) = 100 x (Net Sales - Cost of Sales) / Net Sales Net sales are equal to gross revenue, which is revenue minus sales returns, allowances, and discounts. The cost of sales is essentially the direct costs associated with producing the revenue (a somewhat loose concept). Gross profit represents how much the company made from total revenue after subtracting the direct costs involved in producing that revenue.
What's a good (gross) profit margin?
A higher number is better. Averages vary significantly across industries. Companies with a durable competitive advantage tend to have consistently higher gross profit margins than those that don't. (You want to look at the past ten years.) These companies have the market power to set prices well in excess of costs. In general, a gross profit margin of 40% or better indicates that the company has some kind of durable competitive advantage. In contrast, 20% or below indicates a fiercely competitive industry, where no one company can get a competitive advantage.
What nuances are there to the return on assets (ROA)?
Huge companies with a durable competitive advantage can have low ROA simply because they have a huge amount of assets. This can actually be a good thing because the assets create a barrier to entry.
What are the nuances of looking at (gross) profit margin?
Other expenses can strip away a promising profit margin.
What is the purpose of profitability ratios?
Profitability ratios measure a company's ability to generate earnings. They show how well the company can convert its resources into profits.
How is the return on assets (ROA) calculated?
ROA (%) = 100 x (Net Income / Total Assets)
How is the return on assets (ROA) interpreted?
ROA measures a company's ability to generate earnings from its assets. It indicates how much profit can be derived from each dollar of assets owned by the company.
How is return on equity (ROE) calculated?
ROE (%) = 100 x (Net Income / Shareholders' Equity)
How is return on equity (ROE) interpreted?
ROE measures a company's ability to generate earnings in relation to its shareholders' equity. It indicates how much profit can be derived from each dollar of shareholder's equity. High returns on equity can mean that the company is making good use of the earnings it's retaining.
What nuances are there to return on equity (ROE)?
Some companies choose to use excess cash to issue dividends or repurchase stock instead of retaining the earnings. This can result in negative shareholders' equity and thus negative ROE. The danger is that insolvent companies also show negative ROE. So, if the company has a long history of strong net earnings and a negative ROE, it probably benefits from a long-term competitive advantage. On the other hand, negative earnings combined with a negative ROE is a very bad sign.
What's a good return on assets (ROA)?
The higher the ROA, the better. In general, an ROA above 5% is considered good. That would mean the company can generate $0.05 in annual earnings for each $1 of assets it owns.
What's a good return on equity (ROE)?
The higher the ROE, the better. Averages can vary depending on the industry, but an ROE above 20% is good. This would mean the company can generate $0.20 in annual earnings for each $1 of shareholders' equity.
How is the (gross) profit margin interpreted?
The profit margin indicates how much profit the company earns from each dollar of sales, after subtracting the direct cost of sales. A profit margin of 20% means the company generates $0.20 of profit for every $1 of sales. Of course, this does not include any other expenses.