Basic Business Calculations – Profitability Ratios

Business Calculations Part 4

Profitability ratios, usually expressed as percentages, are useful indicators of a business’s financial success and growth potential. Investors, including business owners are therefore well acquainted with these ratios! The following are the most common of the profitability ratios:

  • Gross Profit Margin
  • Net Profit Margin
  • Return on Assets
  • Return on Equity

Gross Profit Margin

The Gross Profit Margin looks at the proportion of money left over from sales once the cost of those goods has been accounted for. The gross profit margin or the money left over will be used to pay for additional expenses.

Typically, the more efficient the company is, the higher the gross profit margin. This percentage should be compared to other similar-sized companies within the same industry for it to be truly meaningful.

For example, suppose that Plastics Incorporated earned R20 million in revenue from producing plastic jugs and incurred R10 million in cost of sales. Plastics Incorporated’s gross profit margin would be 50%. This means that for every rand that the company earns on jugs, it really has only 50 cents at the end of the day.

  • Gross Profits (Sales – Cost of sales) / Sales

Net Profit Margin

This ratio looks at how much net profit a business is making on sales and is usually expressed as a percentage, (same as Gross Profit margin). As a business owner this ratio should be of particular interest as it represents the percentage of Rands per sale that is available as dividends or drawings.

Net Profit Margin is a useful measure of how your business is performing over time and at a glance you can see whether your business’s net profit has increased, stayed the same, or decreased over the last year. It should also be compared to other companies within the same industry – the higher a company’s profit margin compared to its competitors, the better.

This ratio takes into account all business expenses, including income taxes and interest, making it a useful tool amongst business owners for the insight it gives into a business’s financial well being.

For example, if ABC Clothing are generating sales of R100 000 while its net income is R40 000, its profit margin is R40 000/R100 000 = 40%.

  • Net Profits / Sales

Return on Assets

Expressed as a percentage and sometimes also referred to as “return on investment”, this ratio looks at how effective a company is at using its assets to generate income. A company’s assets are comprised of both debt (borrowed money) and equity.

The higher the Return on Assets the better as it means that the company has generated more income on less investment.

For example, if ABC Clothing has an income of R1 million and total assets of R5 million, its ROA is 20%; however, if another company earns R1 million but has total assets of R10 million, it has an ROA of 10%. If we compare the two companies, we can conclude that the first company is more effective at generating money from its assets (investments) ie. It made a large profit with a smaller investment.

  • Net Income / Total Assets

Return on Equity

Return on Equity or ROE for short, looks at the amount of net income returned as a percentage of shareholders/ owner’s equity. Ie. How much profit has the company generated with the money invested by shareholders.

Remember that Owner’s equity = total assets – total liabilities. It represents what the shareholders “own”.

It makes sense that the higher a company’s ROE, the better. The percentage return can then be compared to other companies within the same industry as well as to what a company might have earned if it had invested money in the stock market or a bank account. It is important that over time, a company earns at the least the same or more than it would in these passive investments otherwise it would seem pointless to spend time, energy and capital on running a business.

In analysing both ROE and ROA, remember to take into account the effects of inflation on the book value of the assets. A company’s financial statements will show all assets at their book value (original cost less depreciation) but the replacement value of many older assets may be significantly higher than their book value. So in essence, a company with older assets should show higher return percentages than a company with newer assets.

  • Net Income / Owner’s Equity

References:

www.investorwords.com
www.beginnersinvest.about.com
www.investopedia.com