Understanding Key Profitability Ratios: A Guide for Investors
Ratios, from being associated with high school math, have become one of the key elements in the finance sector.
The majority of investors rely on various ratios derived from balance sheets for equity, debt, or angel investments.
Most others, who rely on instincts and impulses, ultimately turn themselves into millionaires from billionaires.
In this article, I’ve asked a few investors about the profitability ratios they use to find new opportunities and the key points they wish they knew as newcomers.
This article focuses on profitability ratios and doesn’t go into other domains such as:
Liquidity ratios
Solvency ratios
Activity ratios
Valuation ratios
By definition, profitability ratios are metrics used to assess a business’s ability to generate profit.
Many different variables, including operating costs, equity over time, COGS, and sales are
analyzed to calculate different profitability ratios.
A few years back, a bakery run by an old couple started tracking a few profitability ratios. Nothing outrageous. Just the basics like gross profit and net profit.
While the calculations weren’t as extensive, they were pretty accurate.
They started talking about their process and margins quite publicly.
And at one point, they even started generating 25% net profit consistently.
Today, they own 7 bakeries around Florida with the help of interested investors.
In essence, profitability ratios help investors understand investment opportunities.
Therefore, let’s discuss a few ratios that you may also use to determine potential investments.
Gross Profit Margin
The variables required to calculate gross profit margins are Revenue or sales; and COGS.
Take this example of The Coca-Cola Company’s 2022 Q4 statement of income.
The “Net Operating Revenues” and “Cost of Goods Sold” (COGS) are respectively $ 10,125 million and $4,513 million.
The formula to deduce gross profit is:
Gross profit = (Net operating revenues — COGS)
Therefore, Gross profit = $10,125 — $4,513 = $5,612 million, which has seen a 4% increase in QoQ analysis.
Gross profit margins are critical to understanding the market share of the company and the growth (or regression) they’re making.
If a company, for instance, Coca-Cola, is making significant growth in the market, the operating expenses can be optimized further to increase profit margin.
However, if growth is halted, the profits can’t be maximized despite efforts to optimize assets.
Operating Profit Margin
As a measure of efficiency and comparison metric to industry peers, the operating profit margin is calculated through the variables:
Operating income
Revenue or sales
The formula used to calculate is:
Operating profit margin [%] = (Operating income / Revenue) *100
Again from the Coca-Cola example, the operating profit margin would be ($2,075 million / $10,125 million)*100 = 20.49%, which is significantly higher than the QoQ result of 17.66%.
This should tell you that the company has made its processes more cost-effective and profitable. The better numbers a company has, the more efficient they are in their operations.
Usually, a more than 15% operating profit margin is considered adequate.
Net Profit Margin
Mostly beneficial to assess the risks and as a measure of profitability, the net profit margin is one of the most key profitability ratios. It’s calculated as a percentage after realizing every operational expense and equity loss/income from the gross profit.
The formula for net profit margin is:
Net Profit Margin = (Net Profit / Total Revenue) x 100%
Typically, consolidated net incomes are calculated to disregard the unrealized income of the organization. Unrealized income could be anything from profitable stock investments to appreciating property valuations.
Again from the Coca-Cola example, the consolidated net profit is determined as $2,056 million in Q4, which has reduced from the QoQ income of $2,450 million, while the gross income has increased by 4%. This is due to an increase in the cost of goods and administrative expenses departments.
In this case, the net profit margin for Q4 is (2056/10125)*100 = 20.3%, which was 25.88% the previous year.
Return on Assets (ROA)
Asset calculation is an extensive process for larger corporations. To reduce the operational burden and avoid undue investor stress, yearly return on assets (ROA) is typically calculated instead of quarterly calculations.
While it isn’t the only signal, ROA is a key element for investors to understand the per-dollar efficiency of the company. It lets you know if a company is utilizing its assets effectively or wasting its resources. However, a lower ROA is not always a negative factor. Industries like real estate or utilities often show a below-average number due to the nature of the operations.
The formula for ROA is:
ROA [%] = (Net income / total assets) * 100
For example, the Coca-Cola Company announced $92,763 million worth of assets at the end of 2022, including its properties, trademarks, goodwill, and equity. The net income around that time clocked $9,571 million.
Remember, this is for the whole year and not only Q4.
The ROA during this time would be (9571/92763)*100 = 10.31%, which is adequate, considering the average ROA of 8–9% of S&P 500 companies. A lower number would’ve indicated inefficiency in operations, poor management decisions, low sales, or high expenses.
Return on Equity (ROE)
As an investor, evaluation of profitability, maximization of investor money, and identification of growth opportunities are three key benefits of calculating the return on equity (ROE) of a company.
Typically, ROE refers to the relation between net income and the shareholder’s money and is calculated by the formula:
ROE [%] = (Net Income / Total Equity)*100
Most companies include Total Liabilities and Equity in their balance sheets. However, do remember that liabilities aren’t considered while calculating ROE.
As an example, we again take the Coca-Cola earnings release to deduce that the Net Yearly Income for 2022 was $9,571 million and total equity was $25,826 million (also taking the noncontrolling interest into account).
Therefore, the ROE during the year was (9571/25826)*100 = 37.05%, which is considered a great output by industry standards.
A higher ROE number signifies great usage of investor money and optimization of operations. Again, it can be determined as the ultimate technical indicator, but it can be a signal of potential growth and increased profit.
Earnings per Share (EPS)
EPS or earnings per share allows you to compare the profitability of different companies on a per-share basis. Through the prediction of performance and analysis of profitability, you can make informed decisions as an investor.
The formula used to calculate EPS is:
EPS [$] = (Net income / average outstanding shares)
From the Apple Q4 reports from 2022, the EPS is already calculated. Which can be determined by dividing Net Income ($99,803 million) by basic outstanding shares (16,215,963). Therefore EPS = $6.15
A higher EPS number signifies the potential to pay more dividends to the shareholders. While it isn’t a guarantee of better future performance, it’s a signal of the profitability of the company. However, EPS can be influenced by how the company reports its expenses and earnings.
The Bottom Line
6 key profitability ratios are discussed in this article with adequate examples. If you like the article and want me to write for you, leave me an email at ushnish3@gmail.com with the subject line “hire a writer”.
Thank you.