9.12 Profitability ratios

Ratio Analysis

These ratios indicate how profitable a company is. Some of these ratios are:

(a) Operating Margin (%):

This is defined as

Operating Profit
(Profit before Depreciation, Interest and Tax)
--------------------------------------------------------------X 100
Net Sales

(b) Gross Margin (%):

This is defined as

Gross Profit
(Profit before Depreciation and Tax)
----------------------------------------------X 100
Net Sales

(c) Net Margin (%):

The return on net worth is defined as

Net Profit
------------------- X 100
Net Worth

(d) Return on Net Assets (RONA) / Return on Capital Employed (ROCE) (%):

While discussing the balance sheet we have already pointed out that the capital employed (i.e. shareholder’s fund +loan fund) is equal to the net assets (i.e. net fixed assets + investment + net current assets). Thus, the ROCE and RONA are the same ratios defined as

Profit before Interest and Tax-------------------------------------------X 100
Net Assets or Capital Employed

What does one learn from the profitability ratios?

These ratios are used for judging the health of the company. Hence, you must have the past years’ figures (at least two years) to compare a rise or decline in these ratios over the years. You must also compare these ratios with those of its competitors to determine its strength or weakness in terms of competition. The operating margin, gross margin and net margin indicates the profitability of a company with reference to its sales. A high operating margin shows profitable operations, while a high gross margin also indicates low debt and interest burden.

Return on Net worth (RONW) measures how profitably shareholders’ funds are deployed. RONA or ROCE measure how good the company is in investing in net assets (or in total deployment of funds) for generating profits. An increasing trend of these profitability ratios over the years shows a marked improvement in operation. A decreasing trend proves otherwise. If all competitors reveal an increasing trend of the profitability ratios it means that the industry is booming. Similarly, a declining trend of the profitability ratios would show industrial recession.

To illustrate with an example, let us take companies A, B, C and D and check their gross margins in four successive years. You will observe that the gross margin fell for all companies showing a recession in the industry. Company A all along has performed well, while company B always fared badly. The fall is sharp for company C which can be attributed to an inability to manage crisis after 2007. Company D was quite steady. In terms of future investment, obviously company A or D are the better bets. Company B is not good for investment.