Financial Reporting and Analysis subject For undergraduate students (semester 4)

1. Profitability ratios
Meeting 3

2. profitability ratios show what?
the combined effects of liquidity, asset
management, and debt on operating results
• 1. Gross profit margin
• 2. Operating profit margin
• 3. Net profit margin
• 4. Return on Asset
• 5. Return on Equity

3. 1. Gross profit
margin
2. Operating
profit margin
3. Net operating
margin

4. • 1. Gross profit margin (direct costs)
• Gross profit margin is calculated by looking at revenue minus the cost of goods
required for production.
• 2. Operating profit margin (direct and indirect costs) also (cost of goods sold
and cost of sales)
• Operating profit margin is calculated by taking the gross profit figure and then
subtracting all the indirect costs involved in production and delivery of goods,
such as salaries; marketing and advertising costs; and general administrative
expenses. Often referred as EBIT/sales
• 3. Net profit margin (only cost of goods sold)
• the profit per dollar of sales
• The difference between Net Profit Margin and Operating Profit Margin is that the
former takes only cost of goods sold into account, but the latter takes both cost of
goods sold and cost of sales into account.
• Operating profit margin shows us before interest and taxes how the company is
doing, net profit margin shows after interest, taxes, amortization, and
depreciation

5. Gross profit definition
• Gross profit, the first level of profitability, tells analysts how good a
company is at creating a product or providing a service compared to
its competitors.

6. 1. Gross profit margin
Gross profit/(Revenue-Cost of goods sold) x 100
Revenue/Net revenue/Sales/Net sales
• Is a financial metric used to assess a company's financial health and business
model by revealing the proportion of money left over from revenues after
accounting for the cost of goods sold (COGS).
• Without an adequate gross margin, a company is unable to pay for its operating
expenses. In general, a company's gross profit margin should be stable unless
there have been changes to the company's business model.
• Gross margin changes may also be driven by industry changes in regulation or
even changes in a company's pricing strategy.
• More efficient or higher premium companies see higher profit margins.
6

7. Gross profit margin: example
• Suppose ABC company earns $20 million in revenue from producing
widgets and incurs $10 million in COGS-related expenses. ABC's gross
profit is $20 million minus $10 million. The gross margin is calculated
as gross profit divided by $20 million, which is 0.50, or 50%. This
means ABC earns 50 cents on the dollar in gross margin.

8. Operating income definition
• “Operating income” refers to the profit that a company retains after
removing operating expenses (such as cost of goods sold and wages)
and depreciation.
• “Net sales” refers to the total value of sales minus the value of
returned goods, allowances for damaged and missing goods, and
discount sales.

9. 2. Operating profit margin
Operating profit/EBIT x 100
Revenue/Net revenue/Sales/Net sales
• Operating margin is a measurement of what proportion of a company's revenue is left over after paying for
variable costs of production such as wages, raw materials, etc. It can be calculated by dividing a company’s
operating income (also known as "operating profit") during a given period by its net sales during the same
period.
• Operating margin gives analysts an idea of how much a company makes (before interest and taxes) on each
dollar of sales. Generally speaking, the higher a company’s operating margin is, the better off the company
is. If a company's margin is increasing, it is earning more per dollar of sales.
• A company’s operating margin often determines how well the company can satisfy creditors and create
value for shareholders by generating operating cash flow. A healthy operating margin is also required for a
company to be able to pay for its fixed costs, such as interest on debt, so a high margin means that a
company has less financial risk than a company with a low margin.

10. Operating profit margin: example
• Suppose that Company A earns $12 million in a year with $9 million of cost
of goods sold and $500,000 in depreciation. Also suppose that Company A
makes $20 million in sales during the same year, with $1 million worth of
returns, $2 million in damaged and missing goods and $1 million in
discounts. Company A’s operating margin for the year is then:
• ($12M - $9M - $0.5M) / ($20M - $1M - $2M - $1M) = $2.5M / $16M =
0.1563 = 15.63%
• With an operating margin of 15.63%, Company A is earning about $0.16
(before interest and taxes) for every dollar of sales.

11. Operating profit margin: usage
• Shows how profitable a company is
• A savvy investor may often track a company’s operating margin over time
to determine if the company’s margin has historically been consistent or if
growth in its operating margin is stable.
• It can be used to analyse a particular project within a company, not only
the company itself.
• However it doesn't account for the investment capital that got the
company started. It is important when considering young companies, as
they may be working to recoup initial costs, an effort that will likely not be
reflected in an operating margin.

12. Net profit: definition
• Net profit represents the number of sales dollars remaining after all
operating expenses, interest, taxes and preferred stock dividends (but
not common stock dividends) have been deducted from a company's
total revenue.
• Net profit is one of the most closely followed numbers in finance, and
it plays a large role in ratio analysis and financial statement analysis.
Shareholders look at net profit closely because it is the source of
compensation to shareholders of the company.

13. 3. Net profit margin
otherwise known as profit margin on sales
Net profit/Net income x 100
Revenue/Net revenue/Sales/Net sales
• Shows how much of each dollar collected by a company as revenue translates
into profit.
• Net margins vary from company to company, and certain ranges can be
expected in certain industries, as similar business constraints exist in each
distinct industry. Low profit margins don't necessarily equate to low profits.
13

14. Net profit margin: usage
• Net profit margin is one of the most important indicators of a business's
financial health.
• It can give a more accurate view of how profitable a business is than its
cash flow, and by tracking increases and decreases in its net profit margin,
a business can assess whether or not current practices are working.
• Additionally, because net profit margin is expressed as a percentage rather
than a dollar amount, as net profit is, it makes it possible to compare the
profitability of two or more businesses regardless of their differences in
size.
• Finally, a business can use its net profit margin to forecast profits based on
revenues.

15. Net profit margin: example
• Imagine a business has $100,000 in revenue, but it also has $20,000
in operating costs, $10,000 in COGS and $14,000 in tax liability. Its net
profits are $56,000. Profits divided by revenue equals .56 or 56%. A
56% profit margin indicates the company earns 56 cents in profit for
every dollar it collects.

16. 4. Return on Asset (ROA)
otherwise known as Return on Investment (ROI)
Net Profit/Net income x 100
Total Assets
• Indicator of how profitable a company is relative to its total assets.
• Gives an idea as to how efficient management is at using its assets to generate
earnings.
• Can vary substantially and will be highly dependent on the industry.
• The higher the ROA number, the better, because the company is earning more
money on less investment

17. Return on Asset (ROA): 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.

18. 5. Return on Equity (ROE)
otherwise known as Return on ordinary Shareholders’ Funds (ROSF)
Net profit/Net income x 100
Total Equity
• Measures a corporation's profitability by revealing how much profit a company
generates with the money shareholders have invested.
• Is more than a measure of profit; it's a measure of efficiency. A rising ROE
suggests that a company is increasing its ability to generate profit without
needing as much capital.
• It also indicates how well a company's management is deploying the
shareholders' capital. In other words, the higher the ROE the better. Falling ROE is
usually a problem.

19. Return on Equity: example
• Let's assume Company XYZ generated $10 million in net income last
year. If Company XYZ's shareholders' equity equaled $20 million last
year, then using the ROE formula, we can calculate Company XYZ's
ROE as:
• ROE = $10,000,000/$20,000,000 = 50%
• This means that Company XYZ generated $0.50 of profit for every $1
of shareholders' equity last year, giving the stock an ROE of 50%.

20. ROE: the DuPont formula
• breaks ROE (return on equity) into three parts
• The name comes from the DuPont Corporation that started using this
formula in the 1920s. DuPont salesman Donaldson Brown invented
this formula in an internal efficiency report in 1912