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Profitability Ratios

The Higher the Better (Mostly)

Profitability ratios help you evaluate your company’s ability to generate profits. There are dozens of them, a fact that helps keep financial folks busy. But here we are going to focus on just five. These are really the only ones most entrepreneurs need to understand and use. Profitability ratios are the most common of ratios. If you get these, you’ll be off to a good start in analyzing your financial reports (or any other company’s).

Before we plunge in, however, do remember the artful aspects of what we’re looking at. Profitability is a measure of a company’s ability to generate sales and to control its expenses. None of these numbers is wholly objective. Sales are subject to rules about when the revenue can be recorded. Expenses are often a matter of estimation, if not guesswork. Assumptions are built into both sets of numbers. So profit as reported on the income statement is a product of the art of finance, and any ratio based on those numbers will itself reflect all those estimates and assumptions. We don’t propose throwing out the baby with the bathwater—the ratios are still useful—only that you keep in mind that estimates and assumptions can always change.

Now, on to the five profitability ratios that we promised you.

GROSS PROFIT MARGIN PERCENTAGE

Gross profit, you’ll recall, is revenue minus cost of goods sold or cost of services. Gross profit margin percentage, often called gross margin, is simply gross profit divided by revenue, with the result expressed as a percentage. Look at the sample income statement in appendix A, which we’ll use to calculate examples of all these ratios. In this case the calculation is as follows:

Gross margin shows the basic profitability of your product or service itself, before expenses or overhead are added in. It tells you how much of every sales dollar you get to use in the business—22.2 cents in this example—and (indirectly) how much you must pay out in direct costs (COGS or COS), just to get the product produced or the service delivered. (COGS or COS is 77.8 cents per sales dollar in this example.) It’s thus a key measure of a company’s financial health. After all, if you can’t deliver your products or services at a price that is sufficiently above cost to support the rest of your company, you don’t have a chance of earning a net profit.

Gary Erickson, coleader of Clif Bar, considers gross margin the most important ratio for entrepreneurs to understand, and the one that is essential to take a business to the next level. “Our first product in the bakery was a cookie,” he says. “We had to figure out the total cost of producing that cookie and price it accordingly—enough to make a profit, but not so high that people wouldn’t buy it.” His analysis of gross margin helped him do that.

Trend lines in gross margin are equally important because they indicate potential problems. IBM not long ago announced great sales numbers in one quarter—better than expected—but the stock actually dropped. Why? Analysts noted that gross margin was heading downward and assumed that IBM must have been doing considerable discounting to record the sales it did. In your company a negative trend in gross margin indicates one of two things (sometimes both). Either the business is under severe price pressure, and you or your sales reps are being forced to discount; or else your materials, labor, and other direct costs are rising, driving up COGS or COS. Gross margin thus can be a kind of early-warning light, indicating favorable or unfavorable trends in the marketplace. It can help you anticipate challenges before they materialize.

OPERATING PROFIT MARGIN PERCENTAGE

Operating profit margin percentage, or operating margin, is a more comprehensive measure of your company’s ability to generate profit. Remember, operating profit or EBIT is gross profit minus operating expenses, so the level of operating profit indicates how well you are running your entire business from an operational standpoint. Operating margin is just operating profit divided by revenue, with the result expressed as a percentage:

Operating margin is another key metric for a company owner to watch. It’s a good indicator of how well you and your managers as a group are doing your jobs. A downward trend line in operating margin should be a flashing yellow light. It shows that costs and expenses are rising faster than sales, which is rarely a healthy sign. As with gross margin, it’s easier to see the trends in operating results when you’re looking at percentages rather than at raw numbers. A percentage change shows not only the direction of the change but also how great a change it is.

NET PROFIT MARGIN PERCENTAGE

Net profit margin percentage, or net margin, tells a company how much out of every sales dollar it gets to keep after everything else has been paid for—people, vendors, lenders, the government, and so on. It is also known as return on sales, or ROS. It’s just net profit divided by revenue, expressed as a percentage:

Net profit is the proverbial bottom line, so net margin is a bottom-line ratio. But net margin is highly variable from one industry to another. It is low in most kinds of retailing, for example. In some kinds of manufacturing, it can be relatively high. The best point of comparison for net margin is a company’s performance in previous time periods and its performance relative to similar companies in the same industry. Managers in big corporations don’t spend a lot of time thinking about net profit margin; they can’t affect interest and taxes, the two key differences between operating profit margin and net profit margin. But you, as an owner, may spend lots of time thinking about both interest and taxes, and it is important for you to understand how much of your profit is going to those two items.

All the ratios we have looked at so far use numbers from the income statement alone. Now we want to introduce two different profitability metrics, which draw from both the income statement and the balance sheet.

RETURN ON ASSETS

Return on assets, or ROA, tells you what percentage of every dollar invested in the business was returned to you as profit. This measure isn’t quite as intuitive as the ones we already mentioned, but the fundamental idea isn’t complex. Every business puts assets to work: cash, facilities, machinery, equipment, vehicles, inventory, whatever. A manufacturing company may have a lot of capital tied up in plant and equipment. A service business may have expensive computer and telecommunications systems. Retailers may have a lot of inventory. All these assets show up on the balance sheet. The total assets figure shows how many dollars, in whatever form, are being utilized in the business to generate profit. ROA simply shows how effective the company is at using those assets to generate profit. It’s a measure that can be used in any industry to compare the performance of companies of different size.

The formula (and sample calculation) is simply this:

ROA has another idiosyncrasy by comparison with the income statement ratios mentioned earlier. Tax considerations aside, it’s hard for gross margin or net margin to be too high; you generally want to see them as high as possible. But ROA can be too high. An ROA that is considerably above the industry norm may suggest that the company isn’t renewing its asset base for the future—that is, it isn’t investing in new facilities and equipment. If that’s true, its long-term prospects will be compromised, however good its ROA may look at the moment. ROA is a key ratio for entrepreneurs: as your business grows, you need to be acutely aware of how you are investing for the future, and ROA can help you keep tabs on that. (In assessing ROA, however, remember that norms vary widely from one industry to another. Service and retail businesses require less in terms of assets than manufacturing companies; then again, they usually generate lower margins.)

Return on Investment

Why isn’t ROI included in our list of profitability ratios? The reason is that the term has a number of different meanings. Traditionally, ROI was the same as ROA: return on assets. But these days it can also mean return on a particular investment. What is the ROI on that machine? What’s the ROI on our training program? What’s the ROI of our new acquisition? These calculations will be different depending on how people are measuring costs and returns. We’ll return to ROI calculations of this sort in the following part.

Another possibility if ROA is very high is that a company’s leaders are playing fast and loose with the balance sheet, using various accounting tricks to reduce the asset base and therefore making the ROA look better than it otherwise would. And since ROA is one of the measures that public-company investors look at, there is an incentive to do so. Enron, for instance, set up a host of partnerships partially owned by CFO Andrew Fastow and other executives and then “sold” assets to the partnerships. The company’s share of the partnerships’ profits appeared on its income statement, but the assets were nowhere to be found on its balance sheet. Enron’s ROA was great, but Enron wasn’t a healthy company.

RETURN ON EQUITY

Return on equity, or ROE, is a little different: it tells us what percentage of profit you make for every dollar of equity invested in the company. Remember the difference between assets and equity: assets refers to what the company owns, and equity refers to its net worth as determined by accounting rules.

As with the other profitability ratios, ROE can be used to compare a company with its competitors (and, indeed, with companies in other industries). Still, the comparison isn’t always simple. For instance, Company A may have a higher ROE than Company B because it has borrowed more money—that is, it has greater liabilities and proportionately less equity invested in the company. Is this good or bad? The answer depends on whether Company A is taking on too much risk or whether, by contrast, it is using borrowed money judiciously to enhance its return. That gets us into ratios such as debt-to-equity, which we’ll take up in the following chapter.

At any rate, here are the formula and sample calculation for ROE:

From an outside investor’s perspective, ROE is a key ratio. Depending on interest rates, an investor can probably earn 3 percent or 4 percent on a treasury bond, which is essentially a risk-free investment. So if someone is going to put money into your company—or if you’re going to invest in somebody else’s business—he or you will want a substantially higher return on the equity. ROE doesn’t specify how much cash an investor will ultimately get out of a company, since that depends on the company’s decision about dividend payments and on how much the stock price appreciates until he sells. But it’s a good indication of whether the company is even capable of generating a return that is worth whatever risk the investment may entail.

Again, note one thing about all these ratios: the numerator is some form of profit, which is always an estimate. The denominators, too, are based on assumptions and estimates. The ratios are useful, particularly when they are tracked over time to establish trend lines. But we shouldn’t be lulled into thinking that they are impervious to artistic effort.