Investors, and therefore managers, are particularly interested in the profitability of the firms that they own. As we will see, there are many ways to measure profits. Profitability ratios provide an easy way to compare profits to earlier periods or to other firms. Furthermore, by simultaneously examining the first three profitability ratios, an analyst can discover categories of expenses that may be out of line. Profitability ratios are the easiest of all of the ratios to analyze. Without exception, high ratios are preferred.
However, the definition of high depends on the industry in which the firm operates. Generally, firms in mature industries with lots of competition will have lower profitability measures than firms in younger industries with less competition. For example: grocery stores will have lower profit margins than computer software companies. In the grocery business, a net profit margin of 3% would be considered quite high, but the same margin would be abysmal in the software business.
The Gross Profit Margin
The gross profit margin measures the gross profit relative to sales. It indicates the amount of funds available to pay the firm’s expenses other than its cost of sales.
The gross profit margin is calculated by:
Gross Profit Margin = —————————————————-
In 2004, ROYAL BALI CEMERLANG’s gross profit margin was:
Gross Profit Margin = ———————— = 15.58%
which means that cost of goods sold consumed about 84.42% of sales revenue. You will see that the gross profit margin has declined from 16.55% in 2003.
The Operating Profit Margin
Moving down the income statement, we can calculate the profits that remain after the firm has paid all of its usual (non-financial) expenses.
The operating profit margin is calculated as:
Net Operating Income
Operating Profit Margin = ———————————————————
For ROYAL BALI CEMERLANG in 2004:
Operating Profit Margin = ——————————————- =3.89%
Note that this is significantly lower than the 6.09% from 2003, indicating that ROYAL BALI CEMERLANG seems to be having problems controlling its costs.
The Net Profit Margin
The net profit margin relates net income to sales. Since net income is profit after all expenses, the net profit margin tells us the percentage of sales that remains for the shareholders of the firm:
Net Profit Margin = ——————————————————
The net profit margin for ROYAL BALI CEMERLANG in 2004 is:
Net Profit Margin = —————————————— =1.15%
This is lower than the 2.56% in 2003, because interest expense is increasing faster than sales.
Taken together, the three profit margin ratios that we have examined show a company that may be losing control over its costs. Of course, high expenses mean lower returns, and we’ll see this confirmed by the next three profitability ratios.
Return on Total Assets
The total assets of a firm are the investment that the shareholders have made. Much like you might be interested in the returns generated by your investments, analysts are often interested in the return that a firm is able to get from its investments. The return on total assets is:
Return on Total Assets = ———————————————-
In 2004, ROYAL BALI CEMERLANG earned about 2.68% on its assets:
Return on Total Assets = ——————————————— = 2.68%
Notice that this is more than 50% lower than the 5.99% recorded in 2003. ROYAL BALI CEMERLANG’s total assets obviously increased in 2004 at a faster rate than did its net income (which actually declined).
Return on Equity
While total assets represent the total investment in the firm, the owners’ investment (common stock and retained earnings) usually represent only a portion of this amount (some is debt). For this reason it is useful to calculate the rate of return on the shareholder’s invested funds. We can calculate the return on (total) equity as:
Return on Equity = ——————–
Note that if a firm uses no debt, then its return on equity will be the same as its return on assets. The higher a firm’s debt ratio, the higher its return on equity will be relative to its return on assets.
In 2004 ROYAL BALI CEMERLANG’s return on equity was:
Return on Equity = ————————————————– = 6.45%
Revealed that this ratio has declined from 13.25% in 2003.
Return on Common Equity
For firms that have issued preferred stock in addition to common stock, it is often helpful to determine the rate of return on just the common stockholders’ investment:
Net Income Available to Common
Return on Common Equity = ————————————————-
Net income available to common equity is net income less preferred dividends. In the case of ROYAL BALI CEMERLANG, this ratio is the same as the return on equity because it has no preferred shareholders:
44.22 – 0
Return on Common Equity = —————————————– = 6.45%
The Du Pont Analysis
The return on equity (ROE) is important to both managers and investors. The effectiveness of managers is often measured by changes in ROE over time. Therefore, it is important that they understand what they can do to improve the firm’s ROE, and that requires knowledge of what causes changes in ROE over time.
For example, we can see that ROYAL BALI CEMERLANG’s return on equity dropped precipitously from 2003 to 2004. As you might imagine, both investors and managers are probably trying to figure out why this happened. The Du Pont system is one way to look at this problem.
The Du Pont system is a way to break down the ROE into its components. Let’s first take another look at the return on assets (ROA):
Net Income Net Income Total Asset
ROE = ————————— = ————————- x ——————
Equity Total Asset Equity
Note that the second term is sometimes called the ‘equity multiplier’ and we know it is equal to:
Total Asset 1 1
——————– = —————————————– = ————————
Total Equity 1 – Total debt Ratio 1 – (Total Debt/Total Assets)
Substituting the first above into the second equation and rearranging we have:
Net Income Total Debt
ROE = ———————————– + (1 – ——————————)
Total Asset Total Asset
We can now see that the ROE is a function of the firm’s ROA and the total debt ratio. If two firms have the same ROA, the one using more debt will have a higher ROE.