Profitability Ratios: Gross, Operating & Net Profit Margin, Return On Total Asset & Equity, Du Pont Analysis

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
Gross Profit Margin = —————————————————-
                                   Sales

In 2004, ROYAL BALI CEMERLANG’s gross profit margin was:

                                   600.00
Gross Profit Margin = ———————— = 15.58%
                                   3,850.00

 

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 = ———————————————————
                                         Sales

 

For ROYAL BALI CEMERLANG in 2004:

                                         149.70
Operating Profit Margin = ——————————————- =3.89%
                                         3,850.00

 

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 Income
Net Profit Margin = ——————————————————
                               Sales

 

The net profit margin for ROYAL BALI CEMERLANG in 2004 is:

                               44.22
Net Profit Margin = —————————————— =1.15%
                               3,850.00

 

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:

                                        Net Income
Return on Total Assets = ———————————————-
                                        Total Assets

 

In 2004, ROYAL BALI CEMERLANG earned about 2.68% on its assets:

 

                                        44.22
Return on Total Assets = ——————————————— = 2.68%
                                        1650.80

 

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:

                              Net Income
Return on Equity = ——————–
                              Total 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:

                              44.22
Return on Equity = ————————————————– = 6.45%
                              685.99

 

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 = ————————————————-
                                             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%
                                             685.99

 

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.

Author: Lie Dharma Putra

Putra is a CPA. His last position, in the corporate world, was a controller for a corporation in Costa Mesa, CA. After spending 15 years as a nine-to-five employee, he decided to serve more companies, families and even individuals, as a trusted business advisor. He blogs about accounting, finance and tax, during his spare time, and helps accounting students (around the globe) to understand the subject matter easier , faster. Follow him on twitter @LieDharmaPutra or add him to your circle at Google Plus Lie+

3 thoughts on “Profitability Ratios: Gross, Operating & Net Profit Margin, Return On Total Asset & Equity, Du Pont Analysis”

  1. Pak putra,
    Berkaitan dengan materi ini, saya kebetulan sekali dalam waktu dekat dipercayakan oleh investor membuat suatu usaha jasa dengan modal 2-3 milyar,
    investasi terbesar adalah penyedian alat dan renovasi gedung dengan modal kerja sekitar 1 milyar.
    ———-..
    pertanyaan :
    1. Perhitungan apa dulu yang harus saya lakukan untuk melihat kelayakan usaha tersebut.
    2. Faktor-faktor apa yang seharusnya menjadi pertimbangan lainnya.

    kalau berkenan diberikan contohnya,

    salam

    Arif Motivator
    arif_harsono@prospect.co.id
    http://www.komunitaselang.wordpress.com

  2. @arifmotivator – Financial ratio analysis basically adalah tools yang biasa dipakai untuk mengukur performance suatu. Dengan kata lain tool ini baru akan berfungsi pada usaha yang telah berjalan, sedangkan untuk usaha yang belum berjalan tentunya belum bisa diukur. Walaupun expertis saya bukan “business development”, tetapi saya boleh suggest untuk memakai “SWOT” analysis. Analysis yang menilai factor: Strength, Weakness, Opportunity and Treat baik dari dalam maupun luar perusahaan. Lebih bagus lagi jika dilakukan business (industry) analysis dahulu yang mencakup hingga ke business life-cycle perusahaan yang akan di jalankan. Hasil analysis tersebut bisa dijadikan pertimbangan dasar untuk melihat peluang dan tantangan yang akan dihadapi di dalam menjalankan usaha tersebut nantinya.

    Sukses selalu untuk pak arif!

  3. i try to come across what so call GTA or gross total assets do they have any specific formula to calculate that GTA or measure the size of the banks

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