Profit Lines

Understanding business as an outsider can be a daunting task for some of us, however, if we can understand some of the common ratios it becomes not so daunting. Today we are going to explore the profitability ratios and how they should be looked at while assessing a company.

Ratios

Net Profit Margin - (Sales Revenue - Cost)/Sales Revenue. As you can see it is the residual income left after deducting all the costs. It is one of the most tracked metrics by investors or analysts.

Well, the number alone doesn't serve much purpose. We can follow the below-mentioned instructions while making sense of this ratio.

1. Check the trend of net profit margin across a period of at least 5 years and compare it with the competitors

2. Check the growth rate of revenue and cost, and compare them.

3. If the profit is increasing - If the growth rate of revenue is more, see if it is because of pricing power or control over the cost due to better management or some moat or better quality of the product. Revenue can increase more than cost due to economies of scale as well (verify that)

4. If profit is decreasing - Check if the revenue is decreasing due to lesser sales or decrease in price (maybe price-taker) or the cost is increasing due to raw material price or supply chain or poor management oversight or bargaining power issues or relatively poor quality of the product (maybe mostly with commodity products with low differentiation with price as the overriding factor).

5. Low-profit margin is sometimes a company's strategy to grasp a higher market share.

Gross Margin - (Sales Revenue - Cost of Goods Sold or Sales)/Sales Revenue. As you can see the margin is calculated by deducting the cost of goods sold or sales from revenue. It represents how much money is left after for other expenses like marketing, G&A, R&D etc. and net profit.

1. Check the trend across a period of at least 5 years versus the competitors

2. Check the growth rate of Sales revenue and COGS

3. Sales revenue might increase due to higher prices and increasing demand. This commands pricing power and a moat to the business. Sales revenue increasing before the increase in market demand, which then gets extended to the supply chain, is dependent on management's ability to capture the opportunity. The sales revenue can drop if the company has a strategy to reduce the price to increase market share or in general demand is low.

4. Market dominance can lower the cost of inventory due to the ability to force suppliers to charge lower prices. It can also be due to a change in supplier or an improvement in production cost and maybe a macro-economic reason for commodities. The cost could increase in general due to certain economic changes and due to the nature of competition, the cost cannot be passed on, hence the lower margins. Price takers also face the same issue.

Return on Assets - EBIT/Average Total Assets. The ratio tells us how efficiently has the assets been used by the management to generate higher income for the company.

1. Check the trend across a period of at least 5 years versus the competitors

2. EBIT can increase because the assets are delivering great results and management is ensuring optimum use of the assets. EBIT will also be subjected to general changes in the economy and market factors. Basically, it is affected by the improvement in revenue or reduction in cost.

2.a. EBIT can decrease because the assets were not delivering the results as expected. The quality of assets could be poor or it could be poor management.

3. The average asset could decrease over time because the company is not replenishing the assets. This is a misleading factor that must be seen closely. Assets could be depreciating quickly due to accounting methods as well or may be due to quick usage in the company.

3.a. The average asset could be increasing over time because the asset purchased might have a lag in its use.

Return Equity - (Net Income-Preferred Dividends)/Average Common Stockholding. This ratio is an indicator for the common equity investors, of how much returns they made on their investment in the company.

1. Check the trend across a period of at least 5 years versus the competitors and across industries

2. Common Stockholders don't include retained earnings and other equity-like preferred or convertibles. ROE>ROA means that the return to equity is more than the interest being paid to creditors.

3. The reasons for increased net income have already been discussed and can be more. The common stockholdings can reduce due to accounting adjustments or changes in the nature of business. For eg., The expenses can be taken up on credit, leading to higher liabilities and assets but proportionately smaller equity. The return on equity will show a higher % due to this. It also reflects management's ability to manage the company.

4. ROE>Cost of capital leads to higher valuation

5. The ratio can get altered because of the level of liabilities or assets in the company. The income figure is subject to a lot of accounting play as well.

Hope you enjoyed today's post. Cheers!