PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its

PROFITABILITY RATIOS We have seen that liquidity ratios tell us about a firm’s ability to meet its

immediate obligations. Now we extend our analysis skills by adding profitability ratios, which help us gauge how well a firm is managing its expenses. Profit margin ratios compare components of income with sales. They give us an idea of which factors make up a firm’s income and are usually expressed as a portion of each dollar of sales. For example, the profit margin ratios we discuss here differ only in the numerator. It’s in the numerator that we can evaluate performance for different aspects of the business.

For example, suppose the analyst wants to evaluate how well pro- duction facilities are managed. The analyst would focus on gross profit (sales less cost of goods sold), a measure of income that is the direct result of production management. Comparing gross profit with sales produces the gross profit margin:

Sales Cost of goods sold –

Gross profit margin = ------------------------------------------------------------------- Sales

This ratio tells us the portion of each dollar of sales that remains after deducting production expenses. For Fictitious Corporation for 1999:

Gross profit margin = --------------------------------------------------------------------- = ---------------------------------

For each dollar of sales, the firm’s gross profit is 35 cents. Looking at sales and cost of goods sold, we can see that the gross profit margin is affected by:

Financial Ratio Analysis

■ Changes in sales volume, which affect cost of goods sold and sales. ■ Changes in sales price, which affect sales. ■ Changes in the cost of production, which affect cost of goods sold.

Any change in gross profit margin from one period to the next is caused by one or more of those three factors. Similarly, differences in gross margin ratios among firms are the result of differences in those factors.

To evaluate operating performance, we need to consider operating expenses in addition to the cost of goods sold. To do this, we remove oper- ating expenses (e.g., selling and general administrative expenses) from gross profit, leaving us with operating profit, also referred to as earnings before interest and taxes (EBIT). The operating profit margin is therefore:

Sales Cost of goods sold – – Operating expenses Operating profit margin = --------------------------------------------------------------------------------------------------------------------------- Sales

Earnings before interest and taxes = ---------------------------------------------------------------------------------------

Sales

For Fictitious in 1999:

Operating profit margin = --------------------------------- =

0.20 or 20%

Therefore, for each dollar of sales, Fictitious has 20 cents of operating income. The operating profit margin is affected by the same factors as gross profit margin, plus operating expenses such as:

■ Office rent and lease expenses ■ Miscellaneous income (for example, income from investments) ■ Advertising expenditures ■ Bad debt expense

Most of these expenses are related in some way to sales, though they are not included directly in the cost of goods sold. Therefore, the difference between the gross profit margin and the operating profit margin is due to these indirect items that are included in computing the operating profit margin.

Both the gross profit margin and the operating profit margin reflect a company’s operating performance. But they do not consider how these operations have been financed. To evaluate both operating and financing decisions, we need to compare net income (that is, earnings after deducting interest and taxes) with sales. Doing so, we obtain the net profit margin:

FINANCIAL STATEMENT ANALYSIS

Net income

Net profit margin = ------------------------------ Sales

The net profit margin tells us the net income generated from each dollar of sales; it considers financing costs that the operating profit mar- gin doesn’t consider. For Fictitious, for 1999:

Net profit margin = --------------------------------- =

0.12 or 12%

For every dollar of sales, Fictitious generates 12 cents in profits. Recap: Profitability Ratios

The profitability ratios for Fictitious in 1999 are: Gross profit margin

Operating profit margin = 20% Net profit margin

They tell us the following about the operating performance of Ficti- tious:

■ Each dollar of sales contributes 35 cents to gross profit and 20 cents to operating profit. ■ Every dollar of sales contributes 12 cents to owners’ earnings. ■ By comparing the 20-cent operating profit margin with the 12-cent net

profit margin, we see that Fictitious has 8 cents of financing costs for every dollar of sales.

What these ratios do not tell us about profitability is the sensitivity of gross, operating, and net profit margins to:

■ Changes in the sales price ■ Changes in the volume of sales

Looking at the profitability ratios for one firm for one period gives us very little information that can be used to make judgments regarding future profitability. Nor do these ratios give us any information about why current profitability is what it is. We need more information to make these kinds of judgments, particularly regarding the future profit-

Financial Ratio Analysis

ability of the firm. For that, we turn to activity ratios, which are mea- sures of how well assets are being used.