An Introduction to Profitability Indicators
Would you like to know how you could strengthen your research on potential investments? Getting data (Profitability Indicators) that really makes a difference in assessing an investment could easily raise your investment profits.
The good news is that there’s never been more information available to the armchair investor. The challenge is trying to understand all the financial terms and what they mean.
Profitability indicators are a set of numbers that all investors should understand. These values provide a lot of insight into the performance of the company in question.
There are several profitability indicators. We’re going to examine the most important metrics that can greatly enhance your ability to research equity investments.
Much of the information that you need can be found in a company’s income statement. It’s a great idea to take time to understand every component of that important financial document.
There are four types of profit margins. All of these are the amount of profit as a percentage of net sales. The only difference between the four is the profit value used.
Consider these types of profit margins when researching potential equity investments:
- Gross profit margin = Gross Profit / Net Sales
- This is the highest level of profit margin. Gross profit is simply the total revenue of the firm minus all the costs of production. These costs include raw materials, labor, and overhead in the manufacturing process. These costs are commonly referred to as the ‘cost of goods sold’ or COGS.
- Gross profit margin provides a view of how well a company is using its labor, raw materials, and fixed assets related to manufacturing.
- Raw material costs have the largest impact on gross profit margin.
- Companies that provide a service instead of a tangible product will have a line item ‘cost of merchandise’ or ‘cost of services’ that’s similar to COGS.
- Operating profit margin = Operating Profit / Net Sales
- Operating profit is the total revenue minus all of the sales and administrative costs. These include the cost of the sales force, marketing expenses, and executive salaries. These are often listed as ‘selling, general, and administrative’ costs or SG&A.
- Professional analysts are particularly enamored with this metric as a tool to compare companies within the same industry.
- Management decisions are the major factor in this profit measurement.
- You can tell a lot about the quality of the management team by comparing this value to that of other similar firms.
- Net Profit Margin = Net Income / Net Sales
- If you hear someone referring to a company’s ‘profit margin’ or ‘bottom line’, this is the same value. It’s the number at the bottom of the income statement that represents what’s left after all of the expenses are subtracted, including taxes.
- Pretax Profit Margin = Pretax Profit / Net Sales
- This is the same as net profit margin except taxes haven’t been subtracted yet. You can determine how well a company manages its tax situation by comparing this value to net profit margin.
Other Profitability Indicators
In addition to the four types of profit margins, there are four other primary profitability indicators. These are:
- Return on Assets
- Return on Capital Employed
- Return on Equity
- Effective Tax Rate
Consider how these indicators are relevant to your financial research efforts:
- Return on Assets. This provides insight into how well a company’s management team is utilizing the company’s assets to generate profit.
- Different industries will have dramatically different target numbers.
- Look at your company’s competition and you’ll learn a lot about what an attractive value is for that industry.
- Return on Assets = Net Income / Average Total Assets.
- While the number can be useful to compare businesses within the same industry, it doesn’t provide good information for comparing companies in different industries.
- The best use of return on assets is examining the trend within a company over the past several years.
- Return on Capital Employed. This gives the investor a view of how well a company utilizes debt to create profits. It also provides an understanding of the firm’s ability to create profit from its capital base.
- In a perfect world, a company is using debt to create more profits, not to purchase non-income-producing items or to pay salaries.
- Return on Capital Employed = EBIT / Capital Employed.
- EBIT = Earnings Before Interest and Taxes (Revenue – Operating Expenses + Non-Operating Income).
- Capital Employed = Average Debt Liabilities + Average Shareholder’s Equity. This is all of the capital used by a firm to generate profits. It could also be considered the Total Assets – Current Liabilities.
- Return on Equity. This compares net income to shareholder’s equity. It’s a measurement of the profitability of the company based on shareholders’ investments.
- Return on Equity = Net Income / Average Shareholder’s Equity.
- This is a very popular metric for investors. It lets the investor see how well their investment is being used by the company to create additional profits.
- Comparison among similar companies is reasonable.
- Using it in conjunction with the Return on Capital Employed is the best approach. An excessive amount of debt can skew the return on equity value and provide misleading information.
- Effective Tax Rate. This measures the effective tax rate of a company. It’s a comparison of the income tax expense and the pre-tax income. It takes into account foreign exchange provisions and other factors.
- Effective Tax Rate = Income Tax Expense / Pre-Tax Income.
- Many analysts don’t consider this metric to be highly important for analyzing companies. It’s possible for companies to get one-time tax breaks or to employ clever financial maneuvering to make the effective tax rate look impressive for a single year.
- Most analysts prefer to use operating or pretax profit since it’s based on quality profits rather than tax maneuverings.
Profit metrics are among the most important figures an investor can utilize to research a company. It’s important to understand what the various numbers represent in order to interpret them accurately.
You now know a lot more than you realize. If you consider the components that make up each number, you can draw many logical conclusions about the status of the company in question.
Not all profits are created equal, and one profit measure may be impressive while another is less so. While the profit numbers don’t tell the entire story, they are critical.
Any company’s profitability ultimately ties to the stock price there can be a time lag before the two merge, but it happens eventually.
Ensure that your investments are profitable and likely to continue being profitable in the future by using these profitability indicators.