Course 304: Interpreting the Numbers
Profitability Ratios
In this course
1 Introduction
2 How to Use Financial Ratios
3 Efficiency Ratios
4 Liquidity Ratios
5 Leverage Ratios
6 Profitability Ratios
7 The Bottom Line

How good is a company at running its business? Does its performance seem to be getting better or worse? Is it making any money? How profitable is it compared with its competitors? All of these very important questions can be answered by analyzing profitability ratios.

Gross Margin. You'll recall from our earlier discussion of the income statement that gross profit is simply the difference between a company's sales of goods or services and how much it must pay to provide those goods or services. Gross margin is simply the amount of each dollar of sales that a company keeps in the form of gross profit, and it is usually stated in percentage terms. The higher the gross margin, the more of a premium a company charges for its goods or services. Keep in mind that companies in different industries may have vastly different gross margins.

Gross Margin = (Gross Profit) / (Sales)

Operating Margin. Operating margin captures how much a company makes or loses from its primary business per dollar of sales. It is a much more complete and accurate indicator of a company's performance than gross margin, since it accounts for not only the cost of sales but also the other important components of operating income we discussed in Lesson 301, such as marketing and other overhead expenses.

Operating Margin = (Operating Income or Loss) / Sales

Net Margin. Net margin considers how much of the company's revenue it keeps when all expenses or other forms of income have been considered, regardless of their nature. While net 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.

Net Margin = (Net Income or Loss) / Sales

Free Cash Flow Margin. In Lesson 303, we discussed the concept and importance of free cash flow. The free cash flow margin simply measures how much per dollar of revenue management is able to convert into free cash flow.

Free Cash Flow Margin = (Free Cash Flow) / Sales

Return on Assets (ROA). Return on assets measures a company's ability to turn assets into profit. (This may sound similar to the total assets turnover ratio discussed earlier, but total assets turnover measures how effectively a company's assets generate revenue.)

Return on Assets = (Net Income + Aftertax Interest Expense) / (Average Total Assets)

You'll notice that we are adding back the company's aftertax interest expense to net income in the calculation. Why is that? Return on assets measures the profitability a company achieves on all of its assets, regardless if they are financed by equity holders or debtholders; therefore, we add back in what the debtholders are charging the company to borrow money.

Why are we adding interest back in on an "aftertax" basis? Interest expense is one of the many line items that are either added to or subtracted from revenue to calculate the pretax income amount. This pretax income amount is then taxed to come up with net income. Thus, when the income-reducing effect of interest expense is ultimately filtered down to net income, it is on an aftertax basis.

A company's aftertax interest expense is easy to determine. First, determine its tax rate by dividing its income tax expense by its pretax income. Then plug that figure into the following formula:

Aftertax Interest Expense = (1 - Tax Rate) x (Interest Expense) 

Return on assets is generally stated in percentage terms, and higher is better, all else equal.

Return on Equity (ROE). Return on equity is a straightforward ratio that measures a company's return on its investment by shareholders. Like all of the profitability ratios we've discussed, it is usually stated in percentage terms, and higher is better.

Return on Equity = (Net Income) / (Average Shareholders' Equity)

Next: The Bottom Line >>


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