Profit is the goal of every business in the world, but how do we track the profitability of a company, and how do we compare the profitability of one company to another? Profitability ratios are the answer to both questions. Using the three main profitability margins is the fastest, easiest way to determine the profitability of a company, and the ratios are simple to calculate too!
Revenue growth is great, and what every company strives for as well, but without profitability, no company is going anywhere, and without that profit is doomed to failure at some point down the road.
Eventually, all growth companies come to a fork in the road where they have to decide to focus on profitability, as opposed to growing revenue because the law of economics will kick in eventually and that revenue growth will stop. Once a company reaches this level, profit becomes the engine that continues the party for the company.
Learning how to measure and track the profit of a company is easy, and you can use those ratios to help you compare your company to others in the same industry or competing industries to give you a sense of how well a company uses the money it generates from all those sales.
In today’s post, we will learn:
- What are Profitability Ratios
- What are the Three Main Profitability Ratios
- How do You Evaluate Profitability Ratios
- Profitability Ratios by Sectors
Ok, let’s dive in and learn about profitability ratios.
What are Profitability Ratios?
A company’s most important goal is to make money and keep it, preferably returning some of that money to its shareholders in the form of dividends, share repurchases, or reinvesting in the business.
The importance of profitability ratios should be obvious; we should know how to analyze the different aspects of the business and how well they use their resources and how much income it can generate from its operations.
Learning the different profitability ratios and how to use them is an excellent way to gain insight into the operations and how well a company retains its profits.
Looking at the bottom line or earnings is tempting, but earnings don’t always tell the whole story and can be misleading.
Profitability ratios can provide deeper insights into a company’s efficiency, particularly management control of costs. Unlike ratios like return on assets or return on equity, profitability ratios, which tell us how much money it earns from either its assets or equity. Profitability ratios tell us how much juice a company can squeeze out its revenues.
Profitability margins are a class of financial ratios used in financial analysis, we have covered several of these ratios in the past, such as return on equity, return on assets, or return on invested capital. All of the above ratios are extremely important to any analysis of the company because they cover the efficiency of a company to earn money from its assets, equity, or reinvestment.
Profitability ratios come in three flavors:
- Gross profit margin
- Operating profit margin
- Net profit margin
We will discuss these more in-depth in the next section.
The bonus of ratios is that they allow you to view the company from many different angles and allow you to compare those ratios to itself and other companies. And in the case of profitability ratios, the ability of a company to generate profits from its revenues, as a result of the operations of a company.
As we go through the different profitability margins, you will see that each margin peels away a layer of costs associated with the operations of a business such as taxes, cost of goods sold, interest payments, and so on. All of which have a direct bearing on the profitability of a company. If the company is unable to control those costs, it will not be profitable in the long run, regardless of the amount of revenue it generates, the company will never be able to overcome the increased costs and remain unprofitable.
Now that we have a better understanding of what profitability ratios are let’s look deeper at these ratios.
What are the Three Profitability Ratios?
As mentioned above, there are three main types of profitability ratios that are used to analyze the financial profitability of a company.
The above diagram illustrates the difference between all the profitability ratios and how we can think of the different metrics that we use to analyze companies. Of the above, we have discussed all of them before except for the next three we are going to discuss. You can find our previous discussions here:
Please refer to the earlier articles if you are unfamiliar with these ratios.
Ok, let’s dive in and discuss the three main profitability ratios.
A note before we continue, the higher the ratio, the better. We are looking for a company that generates high-profit margins from all levels of the operations of the company.
To help us, along with our process, we will dissect the profitability ratios of one company to see the different levels of margins and how they affect the company through the process.
The company I would like to use for our examples is Nike (NKE), which has a current market cap of $151.77B and a market price of $97.6.
Gross Profit Margin
The gross profit margin measures gross profit compared to sales revenue. The margin tells us how much profit a company is taking into account the different costs needed to produce the goods or services the company produces.
The higher gross profit margin tells us that the company is operating at a higher level of efficiency in relation to its core operations. Items reflected by this efficiency are the ability to cover costs such as operating expenses, fixed costs, dividends, and depreciation, and also providing net earnings to the company.
A low gross profit margin tells us that the company has a high cost of goods sold, which can tell us that they have poor buying, high labor, low selling prices, low sales, or formidable competition in their niche.
Let’s look at how we can calculate the gross profit margin.
The formula for gross profit margin:
Gross Profit Margin = ( Gross Profit / Net Revenue ) x 100
Ok, let’s get our numbers from the annual reports to calculate the gross profit margin for Nike. All numbers listed below will be in millions unless otherwise stated. Another note, all formulas for the profitability margins will contain numbers taken solely from the income statement.
Now that we have our numbers let’s pull them together from the income statement.
- Revenue – $39,117
- Gross Profit – $17,474
Let’s plug in our numbers to the above formula.
Gross Profit Margin = (Gross Profit/Revenue) x 100
Gross Profit Margin = (17474 / 39177) x 100
Gross Profit Margin = 44.67%
Pretty simple, huh?
One note, you can find the gross profit of any company if they don’t list it on any of the annual or quarterly reports by taking the net revenues and subtracting the costs of goods or the cost of sales, and that will give you the gross profit.
Ok, let’s move on and examine the operating profit margin ratio for Nike.
Operating Profit Margin
The operating profit margin looks at the profit earned from operations of the business before interest expense, and income taxes are removed, compared to the total revenue of the company.
Businesses with high operating profit margins are better equipped to handle fixed expenses, and interest on obligation, and biggest of all, have a better chance to survive economic slowdowns like we are experiencing right now. Another plus is the ability to offer lower prices than the company’s competitors that have lower operating profit margins.
Analyzing management is a central tenet of finding investable companies, and operating profit margin is a tool that helps locate great management teams. The reason for the use of this margin in analyzing management is good management has the ability to substantially improve the profitability of a company by managing the operating costs effectively.
Most companies will list the operating income of a company as a line item referred to as operating income, but not all of them do, as is the case with Nike. To find the operating profit from an income statement, we take Income before income taxes and subtract the Other (income) expense and add back in the interest expense. Voila, we have our operating income.
The formula to calculate the operating profit margin is:
Operating Profit Margin = ( Operating income / Revenue ) x 100
Now, let’s go back to the income statement and find our numbers for our formula.
Ok, now let’s calculate our operating income.
Operating Income = Income before taxes – Other Income + interest expense
Operating Income = $4,801 – $78 + $49
Operating Income = $4,772
Along with our revenue from the income statement of $37,117.
And now, we can plug that into our formula for operating profit margin.
Operating profit margin = ( 4,772 / $39,117 ) x 100
Operating profit margin = 12.19%
That wraps up the discussion about operating profit margin, now let’s move on to the next margin, net profit margin.
Net Profit Margin
The net profit margin, also known as the bottom line, otherwise known as the earnings of the company, and it is the result of all revenues and expenses that are required to operate the company. Items such as taxes, depreciation, costs of goods, labor, administrative, interest expenses have all been accounted for, and the resulting number is the total earned by the company for the quarter or year.
The net profit margin is the relationship between net income and the total revenue of the company. A great reason to consider this margin is that the net profit margin takes all the considerations into account, and it tells you how much money the company makes compared to its revenues or sales.
One negative to the use of the margin is that it can include a lot of one-time expenses or revenues. That “noise” can make it more difficult to compare to other periods or competitors.
A great example of this is noticeable in the income statement of Nike, which we are currently analyzing. From 2017 to 2019, you can see that revenues and all other costs appear to be in line with the preceding years, but the net income is substantially lower for 2018 than the other years. The reason for this is a one-time increase in the income tax expense in 2018, which reduces the net income for that period. When comparing that year’s net income to the other years, it falls a lot compared to the surrounding years.
In and of itself, this is not a huge issue; rather, it is something to be aware of and to take into consideration when using the ratios for any sort of comparisons.
Let’s return to the income statement once again to find our numbers for the net profit margin.
Now, let’s pull our numbers out to plug them into our formula:
- Net income – $4,029
- Revenues – $37,119
The formula for net profit margin is as follows:
Net Profit Margin = ( Net Income / Revenues ) x 100
Net Profit Margin = ( 4029 / 37119 ) x 100
Net Profit Margin = 10.85%
Notice how as we progress down the line from the top of the income statement, the margin percentages get lower as we remove different expenses and charges along the way. Think of this like your checking account and how after you take home your paycheck and start removing items such as rent, utilities, food, and other expense, at the end of the day, what you are left with is your profit to use as you wish.
None of the above formulas are hard, and finding the data to fill them is not difficult either, the biggest trick is knowing how to interpret them, which we are going to discuss further now.
How do You Evaluate Profitability Ratios?
Using financial ratios are a great place to start analyzing companies, but they don’t always tell you the whole story. Using them in financial modeling, such as a discounted cash flow, can be a fantastic way to encompass all aspects of the business to determine the strength and health of any company.
Another way to use the formulas as a way to determine the financial health and stability is to use them in comparison to itself by comparing past quarters and years. Or by comparing the ratios to other competitors to gauge the strength or health of the company.
To put this into practice, let’s use Nike to compare itself to the past few years and quarters on the three profit margins we just calculated, and along with that comparing it to some competitors.
First, let’s compare Nike using the above ratios over the last five quarters to see if there is anything we can see as far as trends.
That is an interesting exercise and a few things that pop out when you do it this way. First, there is not a lot of change from quarter to quarter, and secondly, the net profit margin appears to be on a downward trend quarter by quarter.
The big takeaway when doing an exercise like this by quarter is to find any trends, either good or bad, to investigate further.
Now let’s do the same exercise, except using annual numbers to give us a better idea of any trends.
That gives us a better overview of the yearly performance, and any trends might stand out further, such as the decline in net profit margin, which when looking at the operating profit margin you can see a trend slightly downward, but nothing earth-shattering.
Ok, lastly, let us compare Nike to others in the same industry to get an idea of how the performance of Nike stacks up to its competitors.
The company’s I would like to compare Nike are:
- Adidas (ADS)
- Puma (PUM)
- Skechers (SKX)
Now that was interesting. As we can see from the chart above, Nike looks to have the most profitable company by operating profit and net profit margins. As we go through this exercise, you see that Nike lags in the gross profit margin but makes up for it in the last two categories. That would indicate that Nike has superior operating characteristics and helps it create profit for the company and shareholders.
Whenever analyzing any company throwing together a charts like the ones above is incredibly enlightening. Comparing numbers to itself can help you see trends, but company to company comparisons are much more revealing.
Using the profitability ratios in this manner is the true strength of these margins and help define the financial strength and health of any company you are analyzing.
Let’s look at a few sectors to get an idea for comparison profitability ratios by sector.
Profitability Ratios by Industry
Another way to use profitability margins is to compare them to others in the industry to get a sense of the company’s performance relative to its peers.
Gross Profit Margin
- Oil and Gas Extraction – 36.6%
- Building Construction – 22.4%
- Apparel – 46.3%
- Communications – 53.8%
- Food Stores – 27.7%
- Depository Institutions – 97.4%
- Business Services – 57.2%
Operating Profit Margin
- Oil and Gas Extraction – 5.4%
- Building Construction – 6.8%
- Apparel – 6.2%
- Communications – 11.3%
- Food Stores – 2.2%
- Depository Institutions – 52.7%
- Business Services – 2.3%
Net Profit Margin
- Oil and Gas Extraction – 3.2%
- Building Construction – 4.8%
- Apparel – 2.9%
- Communications – 3.1%
- Food Stores – 1.5%
- Depository Institutions – 27.2%
- Business Services – (2.1)%
The above is just a sampling of the ratios available for all the industries you want to investigate. I would highly recommend you check any company you are analyzing to its peers as a quick reference. I used the website:
Using the above website is a quick, easy way to find comparison information for any company you are searching for, and a great way to determine the financial health and strength of your company.
As I have mentioned in the past, when analyzing a company, we are Sherlock Holmes, and we must gather all of the clues and put them together in a story that helps us determine the overall health and strength of any company we are analyzing.
The clues that we gather help us decide whether that company is worthy of our investment.
Using financial ratios such as the profitability margins like gross profit, operating profit, and net profit helps us determine that strength. The formulas themselves are quite simple to calculate, but using them in comparison to itself, and competitors are where the margins shine.
As with all formulas and margins we discuss, they must be used together to form an idea of the investability of any company, and we should not use them alone, rather they are all clues that can add up to a great investment. In other words, please don’t ever make an investment based on a great gross profit margin alone.
That is going to wrap up our discussion for today.
As always, thank you for taking the time to read this post, and I hope you find something of value on your investing journey.
If I can be of any further assistance, please don’t hesitate to reach out.
Until next time.
Take care, and be safe out there,