Profitability Ratios Flashcards
Gross Profit Margin
Gross Margin = (Revenue − COGS (Costs of Goods Sold)) / Revenue
The higher the gross margin, the more capital a company retains on each dollar of sales
Only figures in the direct costs involved in production
A gross profit margin ratio of 65% is considered to be healthy.
Net Profit Margin
Most Comprehensive measure of profitability
Net Profit Margin = (R - COGS - E - I - T / R) * 100
where: R = Revenue COGS = The cost of goods sold E = Operating and other expenses I = Interest T = Taxes
Measures how much net income is generated as a percentage of revenues received
Net profit margin helps investors assess if a company’s management is generating enough profit from its sales and whether operating costs and overhead costs are being contained
A good margin will vary considerably by industry and size of business, but as a general rule of thumb, a 10% net profit margin is considered average, a 20% margin is considered high (or “good”), and a 5% margin is low.
Operating Profit Margin
Operating Margin = Operating Earnings / Revenue
Where:
(Operating earnings is the profit earned after subtracting: the cost of goods sold (COGS), general and administration (G&A), selling and marketing, research and development, depreciation, and other operating costs.)
Measures the profitability of a company by determining how much of each dollar of revenue received is left over after certain expenses are paid.
Operating profit margin focuses on indirect business expenses such as administrative costs, salaries, marketing costs, and depreciation costs.
For most businesses, an operating margin higher than 15% is considered good.
Should only be used to compare companies that operate in the same industry and, ideally, have similar business models and annual sales.
EBITDA Margin
Earnings Before Interest, Taxes, Depreciation, and Amortization
EBITDA margin = (earnings before interest and tax + depreciation + amortization) / total revenue
Is an earnings measure that focuses on the essentials of a business: its operating profitability and cash flows.
A high EBITDA percentage means your company has less operating expenses, and higher earnings, which shows that you can pay your operating costs and still have a decent amount of revenue left over.
A “good” EBITDA margin varies by industry, but a 60% margin in most industries would be a good sign. If those margins were, say, 10%, it would indicate that the startups had profitability as well as cash flow problems.
Operating Cash Flow Margin
Operating Cash Flow = Net Income + Non-cash Expenses (Depreciation and Amortization) + Change in Working Capital / Revenue
Reveals how effectively a company converts sales to cash and is a good indicator of earnings quality.
Operating cash flow margin uses operating cash flow and not operating income like Operating Margin.
Return on Assets (ROA)
Return on Assets = Net Income / Total Assets
An indicator of how profitable a company is relative to its total assets.
Higher ROA indicates more asset efficiency.
An ROA of 5% or better is typically considered a good ratio while 20% or better is considered great. In general, the higher the ROA, the more efficient the company is at generating profits.
Return on Equity (ROE)
Return on Equity = Net Income / Average Shareholders’ Equity
Measures a corporation’s profitability in relation to stockholders’ equity.
A rising ROE suggests that a company is increasing its profit generation without needing as much capital.
ROEs of 15–20% are generally considered good.
Investors can consider an ROE near the long-term average of the S&P 500 (14%) as an acceptable ratio and anything less than 10% as poor.
Be Warned: higher ROE can be the result of high financial leverage –> double check
Return on Invested Capital (ROIC)
ROIC =Net Operating Profit after Tax (NOPAT) / Invested Capital
Where:
(Invested capital refers to the total amount of money raised by a company by issuing securities to equity shareholders and debt to bondholders.)
The ROIC ratio gives a sense of how well a company is using the money it has raised externally to generate returns.
Should be compared to Weighted Average Cost of Capital (WACC) to determine whether the company is creating value.
Example: Let’s say a company produces a ROIC of 20% and has a cost of capital of 11%. That means the company has created nine cents of value for every dollar that it invests in capital.
A company is thought to be creating value if its ROIC exceeds 2% and destroying value if it is less than 2%.
Return on Investment (ROI)
ROI = (Current Value of Investment − Initial value of Investment) / Initial value of Investment
Where:
(“Current Value of Investment” refers to the proceeds obtained from the sale of the investment of interest or where the value is presently.)
Is a popular profitability metric used to evaluate how well an investment has performed.
It is a comparison of the profits generated to the money invested in a business or financial product.
An average annual rate of return of 10% or more is a good ROI for long-term investments in the stock market.
