Five things that the profitability ratios will tell you about a company - Motilal Oswal

# Five things that the profitability ratios will tell you about a company

We all understand profits as the surplus that a business generates after meetings its costs. But profitability of a business is a lot more complicated. It is actually an important management information input. One of the best ways of evaluating a company’s profitability is to look at relevant profitability ratios. In these ratios, the profit of the company at different levels is evaluated against different parameters. So let us first understand what profitability can tell you about a company; its health and its prospects. We must also understand profitability ratios analysis and interpretation of the same with appropriate profitability ratios example. Let us look at five distinct things that the profitability ratios can tell us about a company and its business.

1.  How much is the company earning as margin on sales
The net profit margin is one of the most common parameters used to evaluate a business and its financial attractiveness. Net profit margin is calculated as under:
Net Profit Margin (NPM) = Net Profit / Net Sales

The NPM tells you how profitable the business is and how much profit you generate for each rupee of product sold. There is nothing like a benchmark NPM but normally, NPMs above 12% for industrial companies is considered to be good. NPMs are important because they tell you whether the product is a high margin product or a low margin product. More importantly, since net profits are used in this case as the numerator, you also factor in the interest costs and the depreciation and taxation costs. The NPM calculates how efficiently the company is rewarding its shareholders as a percentage of its net sales. When we refer to net sales here, we talk of sales net of excise duty (now subsumed into GST).

2.  What does the company earn for its stakeholders?
The downside with the NPM approach is that it only looks how much profit the company earns with reference to sales. Shareholders are interested in knowing how much returns they are earning for the capital provided. That is where Return on Equity (ROE) comes in handy. Here is how ROE is calculated:
Return on Equity (ROE) = Net Profits / Total Equity

In the above case, the total equity includes the equity capital, general reserves and the share premium reserve. What the ROE measures is what is the company doing with all the profits ploughed back into the company. Remember, company profits after meeting all costs, actually belong to shareholders. You can call it equity or net worth; it is one and the same. You need to how well equity shareholders are rewarded by the company.

A different approach is to look at equity and debt (stakeholders) instead of just the equity shareholders. Here you use the Return on Capital Employed (ROCE). Here is how the ROCE is calculated:

ROCE = Earnings before Interest and tax (EBIT) / (Total equity + Total Long Term Debt)

The comparison of ROE with ROCE becomes an important input for shareholders and investors about whether it is more attractive to invest in the company’s equity or its debt.

3.  What do the core operations of the business generate?

Operating profit margin (OPM) is one of the most common ratios to measure the health of a company. It shows how profitable are your core operations. If you are talking about a steel company, then you need to be clear that steel as a business is profitable. If the steel company is earning less on making steel and more on trading steel or from its investments then it is not a sustainable business model. You can also use the Gross profit instead of the Operating profit margin, it still gives a good idea of the core business functioning and its profitability.

4.  You need to know the break-even point for anything you do

One of the very important that the profitability ratios tell us is the break-even point. What do we mean by break-even point (BEP)? It is the level at which you make no profit and no loss. This is the level at which you exactly cover your variable costs and your allocated fixed costs. This BEP forms the core of pricing. You normally price the product as a mark-up over the break-even point. This helps you to work backward and check if your pricing capacity is competitive in the current market conditions or not. Telecom and aviation are two classic examples of sectors where the competition is forcing pricing to a level where it is virtually unprofitable to run these companies.

5.  Is the company in the right business model, or is time for a tweak?
Finally, profitability analysis answers two very important questions about your business model. Am I into the right business and am I running my business right? When you break up your financial profitability into smaller segments, you actually get a clear picture of the right business model you should adopt. Probably, you are maintaining too much inventory or you are too lax on debtor collections. Alternatively, you are focusing too much on low-margin products. It is also possible that your cost structure is too unwieldy (case of Jet Airways versus Indigo). These insights are available to you only when you start breaking up the profitability ratios.

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