Profitability
Some of the management efficiency ratios are measurements of the firm's ability to generate sales given its asset size. These ratios don't address how much of the sales turn into profit. A firm that can generate substantial sales but cannot turn those sales into profits is not generating any returns for its owners. Profitability ratios focus on a firm's ability to generate earnings as compared to its direct expenses and other relevant costs. These types of ratios are usually calculated at different “levels” of the income statement to evaluate the firm's efficiency at different stages of the process.
The first level of profitability is gross margin. You will recall from the discussion of the income statement in Chapter 3 that gross profit is simply the difference between a company's sales and the cost to produce those goods (cost of goods sold). The gross margin ratio is calculated as
This ratio shows how efficiently a business is at using its materials and labor in the production process, and the ratio gives an indication of the pricing, cost structure, and production efficiency of the business. The higher the gross margin ratio, the better.
One step down in the profitability analysis is the operating margin. Operating margin captures how much a company makes or loses from its core operations. It is a much more complete and accurate indicator of a company's performance than gross margin, since it accounts for not only the direct cost of goods sold but also the other important components of operating income, such as marketing and other overhead expenses. Operating margin is calculated as
Analyzing the operating margin is important because the income statement can sometimes be significantly affected by nonrecurring transactions that are not part of a company's core business, such as gains or losses on sales of equipment or tax penalties. The operating margin is a way to measure only the core operations of the firm that are expected to be sustainable into the future.
The final profitability measure is the net profit margin, which is calculated as
Net profit margin considers how much of the firm's revenue it keeps when all expenses or other forms of income have been considered, regardless of their nature. A firm that manages to deliver a greater percentage of its sales as income is doing a good job at keeping costs and other expenses low. The net profit margin indicates what percent of sales is available to shareholders and for reinvestment into the firm.
While net profit margin is important to take note of, net income often contains quite a bit of “noise,” both good and bad, which does not really have much to do with a company's core business, such as gains or losses on property or machinery. Such events can distort both the company's bottom line and the profitability analysis.
The profitability ratios we have considered so far involve only items in the income statement. Another form of profitability analysis is to measure earnings versus a balance sheet item. The two most widely used are return on assets (ROA) and return on equity (ROE). ROA measures a company's ability to turn assets into profit. This is similar to the total asset turnover ratio discussed earlier, but total assets turnover measures how effectively a company's assets generate revenue rather than profit. ROA is calculated as
where T = firm's tax rate.
Notice that the company's after-tax interest expense is added to net income in the calculation. This reflects that return on assets measures the profitability a company achieves on all of its assets, regardless of whether they are financed by equity holders or debt holders; this being the case, we add back what debt holders are charging the company to borrow money. The higher the ROA ratio, the more profit the firm is able to generate from its assets.
The ROE ratio measures a company's return on its investment by shareholders; it tells common shareholders how effectively their money is being employed. ROE is calculated as
Analyzing ROE is important because a company can create shareholder value only if the ROE is greater than its cost of equity capital (the expected return shareholders require for investing in the company given the particular risk of the company). If a firm cannot deliver ROE that is greater than its cost of equity capital, then the firm is actually destroying shareholder wealth. (We examine cost of equity in Chapter 7.)
Because ROA and ROE involve balance sheet items in their calculation, common practice is to use the average of the beginning and ending balances to calculate the ratio for the same reasons discussed above. However, when shorter periods of time are involved with the calculation, then only ending balances can be used.
Quality of Earnings
The ROE ratio can be decomposed to provide a more specific source of a firm's superior or inferior performance. Remember that ROE equals Net Income divided by Shareholders’ Equity. We can rewrite the formula as
where T = firm's tax rate.
By doing the math, this formula condenses to the ROE formula above. You may also notice that we have already seen some of these ratios (profit margin, total asset turnover). The purpose of the formula is to see what is actually driving ROE based on other performance measurements. While some of these drivers are desirable as sources of ROE, others are a source of risk, being unsustainable sources of shareholder value creation.
The first term on the right-hand side of the equation is the profit margin ratio discussed previously, although here we use pretax income. A higher profit margin ratio means that the firm is converting more of its sales to net income available to equity shareholders. Ideally, a firm would like to increase this ratio to improve ROE. The second term is the total asset turnover ratio discussed in the management efficiency section. We previously indicated that a higher ratio indicates that management is efficiently using its assets to generate sales. A firm that is able to generate a higher ROE than its competitors because of its asset turnover has a competitive advantage in efficiency.
The third term in the equation is another way of expressing financial leverage. While financial leverage is discussed more in depth in Chapter 11, it is necessary to point out here that a higher ratio is not necessarily better and can in fact introduce more risk into the firm. Recall from Chapter 3 the basic accounting equation: Assets = Debt + Equity. If assets are financed by either debt or equity, then a higher financial leverage ratio means that the firm is using more debt to finance its assets (a larger numerator and a smaller denominator). While having some debt in the firm's capital structure is encouraged due to the tax deductibility