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Profitability Ratios
What Does Profitability Ratios Mean?
A class of financial metrics that are used to assess a business's ability to
generate earnings as compared to its expenses and other relevant costs incurred during
a specific period of time. For most of these ratios, having a higher value relative to a
competitor's ratio or the same ratio from a previous period is indicative that the company
is doing well.
Some examples of profitability ratios are profit margin, return on assets and return on
equity. It is important to note that a little bit of background knowledge is necessary in
order to make relevant comparisons when analyzing these ratios.
For instances, some industries experience seasonality in their operations. The retail
industry, for example, typically experiences higher revenues and earnings for the
Christmas season. Therefore, it would not be too useful to compare a retailer's fourth-
quarter profit margin with its first-quarter profit margin. On the other hand, comparing a
retailer's fourth-quarter profit margin with the profit margin from the same period a year
before would be far more informative.
What Does Cash Return On Assets Ratio Mean?
A ratio used to compare a businesses performance among other industry members.
The ratio can be used internally by the company's analysts, or by potential and current
investors. The ratio does not however include any future commitments regarding
assets, nor does it include the cost of replacing older ones.
Note: Some investors add interest expense back into net income when performing this
calculation because they'd like to use operating returns before cost of borrowing.
ROA tells you what earnings were generated from invested capital (assets). ROA for
public companies can vary substantially and will be highly dependent on the industry.
This is why when using ROA as a comparative measure, it is best to compare it
against a company's previous ROA numbers or the ROA of a similar company.
The assets of the company are comprised of both debt and equity. Both of these types
of financing are used to fund the operations of the company. The ROA figure gives
investors an idea of how effectively the company is converting the money it has to
invest into net income. The higher the ROA number, the better, because the company is
earning more money on less investment. For example, if one company has a net
income of $1 million and total assets of $5 million, its ROA is 20%; however, if another
company earns the same amount but has total assets of $10 million, it has an ROA of
10%. Based on this example, the first company is better at converting its investment into
profit. When you really think about it, management's most important job is to make wise
choices in allocating its resources. Anybody can make a profit by throwing a ton of
money at a problem, but very few managers excel at making large profits with little
investment.
Calculated as:
ROCE should always be higher than the rate at which the company borrows, otherwise
any increase in borrowing will reduce shareholders' earnings.
A variation of this ratio is return on average capital employed (ROACE), which takes the
average of opening and closing capital employed for the time period.
Net income is for the full fiscal year (before dividends paid to common stock holders but
after dividends to preferred stock.) Shareholder's equity does not include preferred
shares.
There are several variations on the formula that investors may use:
1. Investors wishing to see the return on common equity may modify the formula above
by subtracting preferred dividends from net income and subtracting preferred equity
from shareholders' equity, giving the following: return on common equity (ROCE) = net
income - preferred dividends / common equity.
2. Return on equity may also be calculated by dividing net income
by average shareholders' equity. Average shareholders' equity is calculated by adding
the shareholders' equity at the beginning of a period to the shareholders' equity at
period's end and dividing the result by two.
3. Investors may also calculate the change in ROE for a period by first using the
shareholders' equity figure from the beginning of a period as a denominator to
determine the beginning ROE. Then, the end-of-period shareholders' equity can be
used as the denominator to determine the ending ROE. Calculating both beginning and
ending ROEs allows an investor to determine the change in profitability over the period.
Return on investment is a very popular metric because of its versatility and simplicity.
That is, if an investment does not have a positive ROI, or if there are other opportunities
with a higher ROI, then the investment should be not be undertaken.
Keep in mind that the calculation for return on investment and, therefore the definition,
can be modified to suit the situation -it all depends on what you include as returns and
costs. The definition of the term in the broadest sense just attempts to measure the
profitability of an investment and, as such, there is no one "right" calculation.
This flexibility has a downside, as ROI calculations can be easily manipulated to suit the
user's purposes, and the result can be expressed in many different ways. When using
this metric, make sure you understand what inputs are being used.
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Financial Ratios
Financial ratios are useful indicators of a firm's performance and financial situation. Most
ratios can be calculated from information provided by the financial statements. Financial
ratios can be used to analyze trends and to compare the firm's financials to those of other
firms. In some cases, ratio analysis can predict future bankruptcy.
Financial ratios can be classified according to the information they provide. The following
types of ratios frequently are used:
• Liquidity ratios
• Asset turnover ratios
• Financial leverage ratios
• Profitability ratios
• Dividend policy ratios
Liquidity Ratios
Liquidity ratios provide information about a firm's ability to meet its short-term financial
obligations. They are of particular interest to those extending short-term credit to the firm.
Two frequently-used liquidity ratios are the current ratio (orworking capital ratio) and
the quick ratio.
Current Assets
Current Ratio =
Current Liabilities
Short-term creditors prefer a high current ratio since it reduces their risk. Shareholders may
prefer a lower current ratio so that more of the firm's assets are working to grow the
business. Typical values for the current ratio vary by firm and industry. For example, firms
in cyclical industries may maintain a higher current ratio in order to remain solvent during
downturns.
One drawback of the current ratio is that inventory may include many items that are difficult
to liquidate quickly and that have uncertain liquidation values. The quick ratio is an
alternative measure of liquidity that does not include inventory in the current assets. The
quick ratio is defined as follows:
The current assets used in the quick ratio are cash, accounts receivable, and notes
receivable. These assets essentially are current assets less inventory. The quick ratio often
is referred to as the acid test.
Finally, the cash ratio is the most conservative liquidity ratio. It excludes all current assets
except the most liquid: cash and cash equivalents. The cash ratio is defined as follows:
Receivables turnover is an indication of how quickly the firm collects its accounts receivables
and is defined as follows:
The receivables turnover often is reported in terms of the number of days that credit sales
remain in accounts receivable before they are collected. This number is known as
the collection period. It is the accounts receivable balance divided by the average daily
credit sales, calculated as follows:
Accounts Receivable
Average Collection Period =
Annual Credit Sales / 365
365
Average Collection Period =
Receivables Turnover
Another major asset turnover ratio is inventory turnover. It is the cost of goods sold in a
time period divided by the average inventory level during that period:
The inventory turnover often is reported as the inventory period, which is the number of
days worth of inventory on hand, calculated by dividing the inventory by the average daily
cost of goods sold:
Average Inventory
Inventory Period =
Annual Cost of Goods Sold / 365
365
Inventory Period =
Inventory Turnover
Other asset turnover ratios include fixed asset turnover and total asset turnover.
Financial Leverage Ratios
Financial leverage ratios provide an indication of the long-term solvency of the firm. Unlike
liquidity ratios that are concerned with short-term assets and liabilities, financial leverage
ratios measure the extent to which the firm is using long term debt.
Total Debt
Debt Ratio =
Total Assets
Total Debt
Debt-to-Equity Ratio =
Total Equity
Debt ratios depend on the classification of long-term leases and on the classification of
some items as long-term debt or equity.
The times interest earned ratio indicates how well the firm's earnings can cover the interest
payments on its debt. This ratio also is known as the interest coverage and is calculated as
follows:
EBIT
Interest Coverage =
Interest Charges
Profitability Ratios
Profitability ratios offer several different measures of the success of the firm at generating
profits.
The gross profit margin is a measure of the gross profit earned on sales. The gross profit
margin considers the firm's cost of goods sold, but does not include other costs. It is defined
as follows:
Return on assets is a measure of how effectively the firm's assets are being used to
generate profits. It is defined as:
Net Income
Return on Assets =
Total Assets
Return on equity is the bottom line measure for the shareholders, measuring the profits
earned for each dollar invested in the firm's stock. Return on equity is defined as follows:
A high dividend yield does not necessarily translate into a high future rate of return. It is
important to consider the prospects for continuing and increasing the dividend in the future.
The dividend payout ratio is helpful in this regard, and is defined as follows:
Phantom Gain
What Does Phantom Gain Mean?
A situation that arises when a gain on an investment is offset by a loss in the same
investment, which usually comes from an income tax provision. Phantom gains are
named as such because there is no actual return, although it may initially seem
otherwise.
This is a difficult situation to identify because the losses may not be so apparent on the
surface. For example, let's look at a bondholder who also receives coupon payments
from the same bond.
If the bondholder receives a coupon payment totaling $150 during a one-year period
and then sells the bond during the year for a loss of $130, the bondholder may believe
that he or she has gained $20 during the year. However, the taxes the investor will pay
on the coupon payment will reduce the net payment. Assume that the investor pays $30
in taxes on the coupon payment. This investor has a phantom gain of $20, but in
reality he or she has lost $10.
Rolling Returns
What Does Rolling Returns Mean?
The annualized average return for a period ending with the listed year. Rolling returns
are useful for examining the behavior of returns for holding periods similar to those
actually experienced by investors.
Also known as 'rolling period returns' or 'rolling time periods'.
For example, the five-year rolling return for 1995 covers Jan 1, 1991, through Dec 31,
1995. The five-year rolling return for 1996 is the average annual return for 1992 through
1996, etc.