Profitability Ratios

The Profitability Ratios measure how well a company utilized its resources in generating profit and shareholder value. The long term profitability of a company is vital for both the survival of the company as well as the benefits received by shareholders. The four most commonly used Profitability Ratios are discussed below:

I will be using the financial statements of Cisco Systems, Inc. (CSCO) to illustrate how the ratios are computed. Please refer to my post on Important Financial Ratios For Analyzing Businesses for copy of Cisco's Income Statement, Balance Sheet and Cash Flow Statement.

1) Profit Margin Analysis

There are four level of profit margins; namely the gross profit margin, operating profit margin, pretax profit margin and net profit margin. The objective of the margin analysis is to detect consistency in a company's earnings. Positive profit margin analysis translates into positive investment quality. The margin analysis also helps to measure the management's ability to manage cost and expenses and generate profits. Ultimately, a large growth in sales will amount to nothing if the cost and expenses grow disproportionately.

Formula:
a) Gross Profit Margin = Gross Profit / Net Sales (Revenue)
b) Operating Profit Margin = Operating Profit / Net Sales (Revenue)
c) Pretax Profit Margin = Pretax Profit / Net Sales (Revenue)
d) Net Profit Margin = Net Profit / Net Sales (Revenue)

Where
Gross Profit = Net Sales (Revenue) - Cost of Sales (Cost of Goods Sold)
Operating Profit = Gross Profit - sum of company's Operating Expenses
Pretax Profit = Operating Profit - Interest Expenses
Net Profit Margin = Pretax Profit - Provision for Income Tax + Minority Interest

Benchmark : The profit margin is industry dependent, a comparison of the ratios against historical data to detect consistency and against the industry benchmark to determine under or over performance.

Calculation: The profit margins for Cisco are calculated as follows:
a) Gross Profit Margin = 28,209 / 46,061 = 61.24%
b) Operating Profit Margin = 10,755 / 46,061 = 23.35%
c) Pretax Profit Margin = 10,159  / 46,061 = 22.06%
d) Net Profit Margin = 8,041 / 46,061 = 17.46%

2) Return on Assets (ROA)

This ratio measures how effective a company utilized its assets to generate profits. This ratio is also a measurement of management effectiveness as it illustrate how well management is employing the company's total assets to make a profit. The higher the return, the more efficient is the management in utilizing  the total assets base.

Formula : ROA = Net Income / Average Total Assets
where Average Total Assets = (Previous year-end Total Asset + Current year-end Total Assets) / 2

Benchmark : This ratio is industry dependent. Capital-intensive industries, with a large investment in fixed assets, will generally have a low ROA value as compared to technology or service industries. A comparison against historical data and peers in the same product line is needed in analyzing the ROA of a company.

Calculation :  The ROA for Cisco as at 28 Jul 2012 is 8041 / (91,759+87,095)/2 = 8.99%.

3) Return on Equity (ROE)

The Return on Equity ratio measures how well the shareholders' investment in the company are generating net income. The higher the ratio, the more efficient management is in utilizing its  equity base and the better return is to the investors.

Formula : ROE = Net Income / Average Shareholders' Equity
Where Average Shareholders' Equity = (Previous year-end Shareholders' Equity + Current year-end Shareholders' Equity) / 2

Benchmark : This ratio is industry dependent, however, ROE ratios in the range of 15%-20% is considered  as representing attractive levels of investment. A comparison against historical data and peers in the same product line is needed.

Calculation :  The ROE for Cisco as at 28 Jul 2012 is 8041 / (51,286+47,226)/2 = 16.32%.

Note : Investors cannot look at a company's ROE in isolation. Disproportionate amount of debt can reduce the equity base and thus even a small amount of net income can still produce a high ROE. The ROE needs to be interpreted in the context of a company's debt-equity relationship. Making use of DuPont Analysis can help investors better understand where the movements in ROE come from,

4) Return on Capital Employed (ROCE)

ROCE measures the profitability of a company by expressing its net income as a percentage of its capital employed. Capital employed is the sum of shareholders' equity and long-term finance. ROCE gives investor a clear picture of how the use of leverage impacts a company's profitability. Since ROCE includes long-term finance in the calculation, therefore it is more comprehensive profitability indicator as compared to return on equity (ROE).

Formula : ROCE = Net Income / Capital Employed
where Capital Employed = Average Debt Liabilities + Average Shareholders' Equity

Benchmark : As a general rule of thumb, ROCE should be at least equal to a company's borrowing rate. A higher value of ROCE is favorable indicating that the company generates more earnings per dollar of capital employed.

Calculation : The ROCE for Cisco as at 28 Jul 2012 is 8041 / [(31+588+16,297+16,234)/2 + (51,486+47,226)/2] = 12.21%.