Financial statement ratio - probability ratios

Question 1

Probability ratios

Answer 1

Measure of a firms profitability relative to its assets (operating efficiency) and to its revenues (operating profitability)

• Gross profit margin
• Operating margin
• Net profit margin
• Asset turnover
• Return on assets (ROA)
• Return on equity (ROE)
• Basic EPS
• Diluted EPS
• Dividend yield

Question 2

Gross profit margin

Answer 2

Gross profit / Revenue

A company with a 80% GPM collects $0.80 for every dollar in revenue after accounting for COGS (direct expenses). The higher the margin, the better a company is at converting revenue into profits.

Question 3

Operating margin

Answer 3

Operating profit / Revenue

Like GPM, but captures operating (non-direct) expenses like SG&A.

Question 4

Net profit margin

Answer 4

Net income / Revenue

Like OPM but captures all non-operating income/expenses.

Question 5

Asset turnover

Answer 5

Revenue / average assets

Asset turnover can mean several things – a business with $500 in assets and $1,000 in revenue (2.0x asset turnover) could be far more capital intensive than a business that achieves the same sales with only $100 in assets. Alternatively, it could just have a lot more cash. Comparison of similar companies within an industry might shed light on general efficiency – for example Walmart’s ratio is 2.3, compared to Sears’ 2.0.

Question 6

Return on assets (ROA)

Answer 6

Net income / Average assets

Measures how effective a company is at converting assets into profits, as opposed to just revenue. The higher the ROA the better, although just like with asset turnover, there are many possible scenarios that make this rule of thumb less than perfect.

Question 7

Return on equity (ROE)

Answer 7

Net income / Total equity

One of the primary challenges with ROA is that it commingles a levered measure of profitability (net income is sensitive to leverage via interest expense) with an unlevered measure of assets (assets can be financed by a lot of leverage or no leverage at all – it is independent of the leverage question). The consequence of this is that ROA makes for a poor ratio to use when comparing companies with significantly different rates of leverage. ROE solves this challenge by factoring leverage into the denominator and calculates a return on just the equity value of the firm. This facilitates the analysis across companies with varying degrees of leverage.

Question 8

Basic EPS

Answer 8

Net income less preferred dividends / weighted avg. shares out.

Question 9

Diluted EPS

Answer 9

Diluted net income / weighted avg. diluted shares out.

Question 10

Dividend yield

Answer 10

Dividends / Net income