When analyzing the annual financial statements of a company, the details can be overwhelming, hence some metrics have been coined to help create a story that helps the analyst or users of the analysis make informed economic decisions. There are various categories of this ratios which are Profitability, Liquidity, Solvency, Gearing, Working capital, Investment and Cashflows.
In this series we would focus on the Profitability ratios. Profitability ratios review the operating performance of a company regarding margins and asset utilization. The popular ratios under this category are Gross profit margin, Net profit margin, Asset turnover and Return on Capital Employed.
The Gross profit margin tracks how the company has been able to manage its direct costs against the revenue earned. It is calculated by dividing the difference between gross profit (revenue less cost of sales) by the revenue. The question to review is, how elastic (responsive) is the price of the company’s products to its direct costs? The more elastic the price is the better the gross profit margin can be managed. This helps an analyst understand the ease with which prices can be increased with pressure on direct costs or the efficiency of other strategies, like bulk discounts, customer lock-in offers etc.
The net (operating) profit margin tracks how the company manages its indirect costs. It is calculated by dividing the Net profit (Gross profit, less selling, distribution, and administrative costs) by the revenue. It excludes interest and taxes because it focuses mainly on operating performance. The ability of a company to manage its indirect cost is a major indicator of its performance. Example of review points are, how efficient has the sales force been? How impactful has advertising or logistics support been? It is normal to expect these indirect costs to have a bearing on revenue and conversely improve the operating profit margin.
The asset turnover ratio reviews the efficiency of the utilization of the company assets. The ratio seeks to answer how well have the company put the assets to use for generating revenue. It is calculated by dividing the revenue for the period by the total capital employed by the company. Capital employed is the total of equity capital and interest-bearing liabilities of the company. The higher the ratio the more efficiently the company has put its asset to use.
Finally, the compound ratio called return on capital employed (ROCE) is the ultimate test of the profitability performance of a company. It is calculated as the multiplication of the operating margin and asset turnover. It is best benchmarked against the company’s weighted average cost of capital or its cost of debt. The ROCE of a company should be higher than its cost of debt. This is because ROCE is trying to explain the returns earned (net profit) from all the capital available to it both equity and interest-bearing liabilities, hence the need for it to be higher than the cost of capital or debt. If the ROCE is lower than the benchmark, it implies that the company might struggle to pay back its debt in the long run.
In the next series, we will review liquidity and working capital ratios, see you next time.
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