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 Ratios of Profitability:

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Definitions

  • An Asset is any 'thing' a business can own. Buildings, equipment, and vehicles are examples of assets that can be depreciated, while cash, bonds, and inventories are assets that are not depreciated.
  • Amortization is essentially depreciation for intangible assets (like oil wells, goodwill, etc.)
  • Cost of Goods Sold (COGS) are the expenses for materials and production of products sold. COGS can be found on the income statement as "Cost of Goods Sold."
  • Depreciation is the reduction in value of an asset over the course of its useful life. It can be calculated in several ways.
  • EBIT is an abbreviation for "earnings before interest and taxes." It is found by adding back interest and taxes to net income.
  • Equity is the residual value of ownership shown on the balance sheet. It will always equal "Total Assets" less "Total Liabilities."
  • Net Income is the earnings of a company after satisfying all obligations. It can be found at the end of the income statement.
  • Sales is the revenue from products or services sold. It can be found on the income statement.
  • Total Assets is the sum of current assets (like cash), fixed assets (such as buildings), and other assets (i.e., goodwill). It can be found on the balance sheet as "Total Assets."
  • Total Debt is the combined amount of current liabilities and long-term liabilities. It can be found on the balance sheet as "Total Liabilities."

 

Basic Earning Power Ratio

  • The Basic Earning Power Ratio isolates earnings from uses of leverage.
  • Given Earnings Before Interest and Taxes (EBIT) from a company's income statement and total assets from the balance sheet:

    EBIT = Net Income + Interest + Taxes

    Basic Earning Power = EBIT / (Total Assets)

  • Generally, the higher the ratio, the more raw earnings potential of the company.
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    Earnings Per Share
    • Earnings Per Share (EPS) indicates how much profit the company earns for each share of common stock outstanding.
    • Given net income from a company's income statement and the number of shares outstanding:

      Earnings Per Share = (Net Income) / (Number of shares of common stock outstanding)

    • Generally, the higher the ratio, the more potential value for the stock price.

     

    Gross Profit Ratio
    • The Gross Profit Ratio indicates how much of each sales dollar is available to pay expenses.
    • Given sales and cost of goods sold from a company's income statement:

      Gross Profit Ratio = (Sales - Cost of Goods Sold) / (Sales)

    • Generally, the higher the ratio, the more from easily expenses can be covered from sales.

     

    Profit Margin
    • The Profit Margin Ratio indicates how profitable a company's sales are.
    • Given net income and sales from a company's income statement:

      Profit Margin Ratio = (Net Income) / (Sales)

    • Generally, the higher the ratio, the more profit earned from each dollar in sales.

     

    Return on Assets
    • Return on Assets (ROA) shows after-tax profit as a percentage of total assets.
    • Given net income from a company's income statement and total assets from the balance sheet:

      Return on Assets = (Net Income) / (Total Assets)

    • Generally, the higher the ratio, the greater the profit from corporate assets.

     

     

    Return on Assets (Du Pont)
    • The Du Pont method of calculating Return on Assets (ROA) relates asset turnover and profit margin as factors in reaching the return on assets.
    • Given sales and net income from a company's income statement and total assets from the balance sheet:

      ROA (Du Pont) = ((Net Income) / Sales) X ((Sales) / (Total Assets))

    • Returns on profit margin are magnified by total asset turnover, so an increase in either affects the ROA.

     

     

    Return on Equity
    • The Return on Equity Ratio (ROE) relates profitability to ownership by showing income as a percentage of equity.
    • Given net income from a company's income statement and total assets from the balance sheet:

      Return on Equity Ratio = (Net Income) / Equity

    • Generally, the higher the ROE, the more profit is earned for owners of the company.

     

     

    Return on Equity (Du Pont)
    • The Return on Equity (Du Pont) Ratio relates ROA to the equity multiplier.
    • sales and net income from a company's income statement and total assets and equity from the balance sheet:

      ROE (Du Pont) = ((Net Income) / Sales) X ((Sales) / (Total Assets)) X ((Total Assets) / (Equity))

    • Previously (see ROA Du Pont) we showed ROA as a factor of profit margin and asset turnover. Now we add financial leverage to reach ROE. Generally, the higher the ratio, the greater the profit for owners.

     

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