Profitability Ratio Analysis: Financial Ratio Analysis Explained
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Profitability Ratio Analysis: Financial Ratio Analysis Explained
Time Markers:
1) The Profit Margin 1:17
2) The Gross Profit Margin 5:47
3) The Return on Assets 14:28
4) The Return on Equity 21:47
5) Different ways to conduct ratio analysis 27:56
6) Key ideas with all ratio analysis 29:06
1) THE PROFIT MARGIN
Tells us how much profit is generated from sales.
Percentage of sales revenue that ends up as profit Good indicator of cost control and/or pricing power.
Profit Margin Formula:
Profit Margin = Net Income / Sales Revenue Example
Where do we find the Required Inputs?
Net Income: From the Income Statement
Sales Revenue: From the Income Statement
How to Interpret Changes in the Ratio:
Expenses have changed in relation to sales...
Management is effective with cost control
Economies of scale are being utilised.
Sales Revenue has changed in relation to expenses...
Change in pricing power (bargaining position with consumers)
Change in state of the economy and aggregate demand
2) THE GROSS PROFIT MARGIN (Very important for resellers and manufacturers)
Profit between cost of inventory and sales price.
How much sales revenue left to cover profit and all other expenses.
Gross Profit Margin Formula:
Gross Profit Margin = (Sales Revenue - Cost of Goods Sold) / Sales Revenue
Where do we find the Required Inputs?
Sales Revenue: From the Income Statement
Cost of Goods Sold: From the Income Statement
How to Interpret Changes in the Ratio:
Sales Revenue has changed in relation to cost of goods sold...
Change in pricing power (bargaining position with consumers)
Change in product or aggregate demand (without a flow through the supply chain yet)
Market competitive position and pressures
Cost of Goods Sold has changed in relation to sales revenue...
Power within the supply chain
Change in supplier or production efficiency Changes in prices of particular commodity inputs
3) RETURN ON ASSETS
Return generated by the assets for those who funded the assets.
Insight into success of management in income generating asset allocation and utilisation.
Return on Assets Formula:
Return on Assets = (Income beforeTax + Interest Expense) / ((Assets at Start of Period + Assets at End of Period) / 2)
Where do we find the Required Inputs?
Income before Tax: From the Income Statement
Interest Expense: From the Income Statement
Assets at Start of Period: From the Previous Balance Sheet
Assets at End of Period: From the Current Balance Sheet
How to Interpret Changes in the Ratio:
Profitability has changed in relation to the level of assets...
Management is getting ‘more from less’ in regards to assets
Management has made good asset allocation decisions in terms of revenue
Management has good control of costs in relation to expenses Previously mentioned reasons: e.g. economy, market power, competitive position
Level of assets have changed in relation to profitability...
Assets may have suddenly increased through large, recent
CapEx Assets may not be being replaced or replenished at the same rate
Particular choice of depreciation/amortisation policies
4) RETURN ON EQUITY
Return generated for the owners of the business, the common stockholders.
Insight into success of any leverage used (when comparing to return on assets).
Return on Equity Formula:
Return on Equity = (Net Income - Preference Dividends) / ((Common Stockholder Equity at Start of Period + Common Stockholder Equity at End of Period) / 2)
Where do we find the Required Inputs?
Net Income: From the Income Statement
Preference Dividends: From the Income Statement or Investor Relations
Equity at Start of Period: From the Previous Balance Sheet
Equity at End of Period: From the Current Balance Sheet
How to Interpret Changes in the Ratio:
Profitability has changed in relation to the level of common stockholder equity...
Management performance is changing in the eyes of, and on behalf of, the owners/employers
Previously mentioned reasons: e.g. economy, market power, competitive position, cost control, asset utilisation
Common Stockholder Equity has changed in relation to profitability...
The level of liabilities have changed (and thus equity)
A stock issue or stock buyback (i.e. equity levels have changed)
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