We devoted previous posts to two important profitability ratios: return on invested capital (ROIC) and return on common equity (ROCE). These two metrics are arguably the most important metrics for determining the economics of a business and how well management is utilizing the company’s resources. However, there are several other ratios which can help managers and investors analyze a company’s profitability.
Before we begin, we should note that the profitability ratios presented here are generic ratios – the type of ratios referenced in standard finance textbooks and used by stock market analysts. In contrast, different industries will require different ratios which are specific to those industries. For example, retailers may use sales or gross margin per square foot, restaurants may use sales per customer, etc. Managers and investors should use these generic ratios in conjunction with the more industry-specific ratios when analyzing business performance.
ROIC and ROCE
We devoted separate posts to return on invested capital (ROIC) and return on common equity (ROCE), highlighting the importance these metrics serve in determining a company’s profitability and resource utilization. So, we’ll only briefly review them here (we’re including them so we have a reference to all of the profitability ratios in one place).
ROIC is defined as net operating income after taxes (NOPAT) divided by the average amount of investment capital in the business over the same period. This measure shows the amount of operating income per dollar of total capital.
ROIC = NOPAT ÷ Average Total Capital
We calculate NOPAT by making adjustments to the P&L statement for nonrecurring items, such as a large settlement on a liability or the gain on the sale of an asset. We then take earnings before interest and taxes (EBIT) and multiply this figure by 1 minus the tax rate (Tc)
NOPAT = EBIT x (1 – Tc)
Because we exclude interest expense, NOPAT gives the amount of operating income available to all capital providers.
In the denominator, we use total debt and total shareholder equity on the balance sheet, making sure to include long-term lease obligations and exclude any non-operating assets.
ROCE calculates the amount of operating income available per dollar of equity capital. Because firms may issue preferred stock, we use only the common equity. ROCE is calculated as net income from operations (NIO) divided by the average amount of common equity capital.
ROCE = NIO ÷ Average Equity Capital
Many financial texts will use net income in the numerator. Since net income refers to the bottom line on a P&L, unadjusted for nonrecurring or nonoperating items, we use net income from operations (NIO) instead. NIO subtracts from NOPAT the interest expense after-tax, thus showing the amount of income available on equity capital.
NIO = NOPAT – [Interest expense x (1 – Tc)]
ROCE can be broken down into components using the DuPont formula.
ROCE = (NIO ÷ Sales) x (Sales ÷ Average Total Assets) x (Average Total Assets ÷ Average Common Equity)
The DuPont formula shows the ROCE as the production of profit margin, capital intensity, and leverage. These three components are the levers which can influence ROCE.
Both ROIC and ROCE should be compared with their relevant costs. For ROIC, we compare the result against the firm’s weighted-average cost of capital (WACC). For ROCE, we compare the result with the firm’s cost of common equity capital. Firms which consistently earn returns exceeding their capital costs create value for their owners.
Gross Profit Margin
Gross profit refers to sales minus cost of goods sold (COGS). COGS represents the inventory which has been sold during the period.
Gross profit margin is the gross profit as a percentage of sales.
Gross profit margin = Gross Profit ÷ Sales
Gross margin is the percent of sales which is available to pay operating expenses. Therefore, all else equal, the higher the gross profit margin the higher the operating income.
One consideration when using gross profit margin is the method the firm uses for calculating inventory and COGS. In brief, a company which purchases and sells inventory must have some means of accounting for the units which have been sold and the value of the units remaining in inventory. Under U.S. Generally Accepted Accounting Principles (GAAP), companies can choose from the following methods: specific identification, weighted-average, first-in first-out (FIFO), and last-in first-out (LIFO).
For firms which sell large-ticket items, such as vehicles or large appliances, the specific identification method is appropriate as it is easy to match the sale with the specific unit being sold. For firms which sell many smaller products, specific identification of inventory is impractical. These firms must make a “flow” assumption as to which items are being sold in a period. For example, a lumber supply house will make many purchases from the lumber mills. These purchases will likely be at different costs. Therefore, the supply house must determine which pieces of lumber are being sold.
For flow assumptions, firms can choose to use the weighted-average, FIFO, or LIFO methods. Under the weighted-average method, the firm calculates an average unit cost based on beginning inventory and subsequent purchases. Under the weighted-average method, both COGS and ending inventories are recognized without regard to the order in which inventories were purchased.
Under the FIFO method, the firm assumes that the oldest inventory purchases are sold first. In a period of rising prices, FIFO has the effect of understating COGS (and overstating profit margin), while leaving a more accurate value of ending inventory (as items left in inventory more closely approximate replacement cost). LIFO, on the other hand, assumes that the most recent inventory purchases are sold first. Thus, LIFO gives us more accurate COGS and gross profit but understates ending inventory (which contains older costs).
While a full treatment of financial statement adjustments is beyond the scope of this post, the above discussion highlights how accounting policy can distort economic reality. In the case of gross margin, the measure will be most accurate when LIFO is used. If LIFO is not used, then managers and investors should make the necessary adjustments to the P&L so that COGS reflects LIFO accounting.
Operating Margin
Operating margin takes the margin calculation one step further by subtracting operating expenses. This measure tells us how much revenue is left after paying the cost of goods and operating expenses. Operating margin is calculated as earnings before interest and taxes (EBIT) divided by total revenue.
Operating Margin = EBIT ÷ Total Revenue
As we have previously stated, EBIT should be a reasonable proxy for the amount of pretax operating cash flow for the period. For this to be so, managers and investors must adjust the P&L so best to reflect revenues and expenses from ongoing operating sources.
By using a measure of income which excludes interest expense and taxes, the operating margin facilitates comparison among companies with different levels of debt.
Net Profit Margin
Net profit margin is the amount of after-tax operating profits per dollar of revenue. Net profit margin is defined as net income from operations (NIO) divided by total revenue.
Net Profit Margin = NIO ÷ Total Revenue
Many finance textbooks will use net income in the denominator. We use net income from operations (NIO) as it adjusts for the impact of nonoperating and nonrecurring income and expenses.
Return on Assets
Return on Assets (ROA) measures the amount of net operating income per dollar of total assets. It is calculated as NIO divided by average total assets for the period.
Return on Assets = NIO ÷ Average Total Assets
One consideration in using ROA is to include only operating assets in the denominator. We do this to be consistent and match operating income with those assets relevant to the generation of that income.
Conclusion
Profitability ratios help managers and investors determine the operating health of the business.
To enhance the usefulness of these profitability ratios, managers and investors must adjust the P&L and the balance sheet to reflect only sustainable operating sources.
The most useful of these ratios are the return on invested capital (ROIC) and return on common equity (ROCE). While margin ratios, such as the gross margin percentage and the operating margin percentage, are important, ROIC and ROCE measures the operating earnings relative to the capital needed to generate those earnings.
