This article is about how to measure the profitability of companies. We will learn how to tell if a company is profitable. We’ll see which numbers can measure profitability. We can perform such an analysis by the use of ratios.

These ratios highlight the ability of a company to generate profits relative to its sales and assets/capital. The higher the ratios better is the profitability. A high ratio is an indicator of the ability of a company to generate higher sales and profits.

Table of Contents

• The Concept of profitability measurement.
• Margin analysis.
  • Gross profit margin.
  • Operating profit margin.
  • Net profit margin.
• Return analysis.
  • Return on Asset (ROA).
  • Return on Equity (ROE).
  • Return on Capital Employed (ROCE).

The Concept – How To Measure The Profitability

To measure the profitability of a company, we can use two types of ratios: margins and returns.

• Margins: These are financial ratios that highlight the percentage of sales/revenue getting converted into profits. One can use multiple ratios to know about the profit-making capacity of a company. Example of it is gross profit margin, operating profit margin, and net profit margin. 
• Returns: These are ratios that highlight the returns a company/business is generating for its owners. To run a business, the owner sources capital and build assets. It is interesting to know how much profit the company can generate per hundred rupees invested in it. Examples of return ratios we can use ROA, ROE, and ROCE. 

Different margin ratios highlight the degree of operating efficiency of a company. They tell about the efficiency of the company in producing goods and services (gross margin) and running the overall operations (operating margin). Net profit margin highlights the ability of a company to yield profits after accounting for all types of costs including D&A, interest, and taxes. 

Different return ratios highlight the resources utilization by the company to yield profits. A combination of ROA, ROE, and ROCE digs deeper into the ability of a company to generate returns.

The best use of profitability ratios is in comparison with the past numbers. This way, the ratios not only give us the quantum of profitability but also establish a trend. As an investor, we would like to see a growing trend.

Margin Analysis vs. All Expenses of a Company

The margin analysis of a company scrutinizes how different categories of expenses stack up against the revenue. Margin analysis is not only about the numbers. An experienced person can also picturise the costs of a company, just by looking at the margins. How we retail investors can do a similar picturization?

I try to recall this infographic every time I see the margin ratios of a company.

The above comparison of a company’s revenues, expenses, and margins is very effective in drawing conclusions out of the deeper fundamental analysis.

Generally speaking, for a manufacturing company, the distribution of expenses is shown above. Out of all the expenses, about 60% of it is used by the COGS. The next major cost head is the operating expense (20%).

A company whose COGS is 60% will display a gross margin higher than 40%. 

Gross margin = (Operating Revenue – COGS) / Operating Revenue

Similarly, for a company whose operating margin is 30%, we will know that its COGS plus operating expenses will be more than 70%.

For non-manufacturing businesses like IT, Finance, and Services, among others, COGS is almost zero. Hence for such companies, the gross profit margin will show as 100%. But such a high number does not mean that the company is very profitable. The actual profitability of such companies is evident from their operating profit margins. 

Gross Profit Margin Ratio

It is a ratio that highlights how much gross profit the company can generate for every hundred rupees of sales. Suppose, the gross profit of a company is 30%. It means that the company is generating gross profits of Rs.30 for every Rs.100 revenue it earns from the sale of its products and services (operating income). 

The formula for the gross profit margin looks like this:

COGS is an abbreviation for the Cost of Goods Sold. It represents the total cost undergone to produce salable goods and services. As an investor, I would like to see how cost-intensive are the products for its company. Less cost-intensive products (smaller COGS) will yield a higher gross profit margin. 

If a company maintains or improves its gross profit margins over time, is a strong indicator of pricing power (economic moat). 

Operating Profit Margin

Suppose a company has a manufacturing facility that it uses to produce goods for its customers. All costs that are directly accountable for the production of goods fall under the category of COGS. 

But there are associated costs, though indirectly, which are essential to run the manufacturing facility. They come under the head of “operating expenses.” A few examples of operating expenses are listed below:

• Maintenance and Repairs.
• Research & Development.
• Rent
• Insurance
• Sales & Marketing.
• Office Supplies.
• Property Tax.
• Salaries & Wages of Employees (indirect labor).
• Others.

The formula for operating profit margin looks like this:

Please note that the inclusion of D&A is a must in evaluating operating margins. D&A works as a proxy for the costs associated with the upkeep of equipment/assets of the company. 

Net Profit Margin

Net margin is the bottom line of a company. It displays the profitability of a company after considering all costs associated with it (all expenses). 

In the calculation of net margin, all sources of income must be considered. All income includes revenue from operations and income from other sources.

The best use of net profit margin is in the calculation of EPS. But I prefer the use of gross profit margin and operating margin over net margin. Why? Because the net margin is calculated using income from other sources. Hence it dilutes the authenticity of the displayed profitability. 

On expense head as well, there are some expenses that are one-time or exceptional in nature. In net margin calculation, even one-timers are included. Again I feel they are not fair indicators of a company’s profitability. Hence I hesitate in comparing it to the margins of other companies. 

The formula for net profit margin looks like this:

Return on Asset (ROA)

When the net profit is expressed as a percentage of the total asset, it is called ROA. The significance of ROA is that it highlights the ability of its assets to yield profits. A higher ROA number means better utilization of the company’s assets.

In terms of formula, ROA looks like this:

Companies of sectors like steel, cement, auto, oil & gas, banks are capital intensive sectors. It means, to yield every extra Rupee of net profit, they need more underlying assets. ROA of such companies is low. 

Companies from service sectors like IT, NBFC’s among others, have a high ROA. 

You can also read about asset turnover to get a better view of asset utilization. 

Return on Equity (ROE)

When the net profit is expressed as a percentage of the total equity, it is called ROE. The significance of ROA is that it highlights how profitably the company is using the owners/shareholders’ funds to yield profits. A high ROE company may not require loans from banks to manage its working capital. But this does not mean that a high ROE company may not seek debt. If the company is in expansion mode, it will require long-term loans to feed its CAPEX demands. 

In terms of formula, ROE looks like this:

Out of the total asset, only the equity portion is compared with the profits. For stock market investors, ROE is the best ratio for comparison with peer companies. 

Return on Capital Employed (ROCE)

ROCE is a measure of how much EBIT a company is making for every Rupee of total capital fed into the business. A positive ROCE number indicates that the business model of the company is profitable. 

In terms of formula, ROCE looks like this:

A high ROCE number indicates that the company is profitable enough to pay its creditors and owners. A company with a high ROCE will also pay the taxes to its government, thereby contributing to the country.

To measure the profitability of a business using only one ratio, I’ll use ROCE. For me, it is one of the most reliable profitability indicators.

Conclusion

How to tell if a company is profitable or not? To do it, we must open the company’s balance sheet and profit and loss account. These two reports can be used to measure the profitability of a company using margin ratios and return ratios.

In this article, we have used three types of margins: gross margin, operating margin, and net margin. We have also used three return ratios for profitability analysis: ROA, ROE, and ROCE. 

A combination of high margins and high ROCE is a better indicator of a company’s profitability. 

I hope you enjoyed reading the article. 

Have a happy investing.

Suggested Reading:

• How to read a cash flow report.
• Most profitable companies in India.
• Operating profit margin of a company.
• Detailed analysis of profit margin of companies.