Profitability metrics / Profit margins
Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10-9. Copyright © 2011 by Marty J.Schmidt.Revised 13 January 2012.
The Meaning of Profitability Metrics
Profitability metrics are designed to answer questions about a company's financial performance and financial position such as these:
• Is the company profitable?
• Is it making good use of its assets? Is it getting a good return on its investments in assets?
• Is it producing value for its shareholders/owners?
• Is the company able to survive and grow?
Profitability metrics represent a profit-making company's most important business objectives and the company's ability to reach them. These metrics are based primarily on data from three primary financial accounting statements: the income statement, the balance sheet, and the statement of retained earnings. This encyclopedia entry uses data from these statements to illustrate six of the most commonly used profitability metrics:
- Gross margin / Gross profit
- Operating margin / Operating profit
- Profit margin on sales / Net profits on sales
- Return on total assets (ROA)
- Return on equity (ROE) / Return on owners investment / Return on net worth / Return on common equity
- Earnings per share (EPS)
• Profitability vs. Profits
• Profitability as a Business Objective
• Six Profitability Metrics
– Profits and Profit Margin Profitability Metrics
1. Gross Margin / Gross Profit
2. Operating Margin / Operating Profit
3. Net Profit on Sales / Profit Margin
– Profitability Metrics With an Investment Viewpoint
4. Return on Total Assets
5. Return on Equity (ROE) / Owners Investment /
Net Worth / Common Equity
6. Earnings per Share (EPS)
• Sample Income Statement
• Sample Balance Sheet
• Sample Statement of Retained Earnings
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Profitability vs Profits
Note that there is an important difference between a company's profits for a period and its profitability.
- Profits: Actual monetary value earned in the period. Profits are reported in currency units ($, €, £, or ¥, for instance).
- Profitability: The company's ability to earn profits, measured as a ratio comparing profits to the costs of earning those profits. These comparisons are profitability metrics.
A firm can earn profits but still be relatively unprofitable, compared to other companies in the same industry, or compared to other potential uses of the company's assets.
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Profitability as a Business Objective
In principle, profit making companies exist and operate primarily to create value for their owners. The company's primary way of doing this is by earning income (profits). Once profits are declared, there are essentially only two things the company can do with them:
- Declare all or part of the profits as retained earnings, which increases owner value by increasing owner's equity on the balance sheet.
- Distribute all or part of the income to the company owners (shareholders) as dividends—a more direct way to provide owner value.
Profitability metrics measure the company's ability to earn profits and are, therefore, a subject of keen interest to its owners (investors who own shares of stock in the company) and potential investors. The company must earn profits, moreover, in order to survive, compete, and grow. For these reasons, profits and profitability metrics are also of high interest to company directors, management, employees, and competitors.
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Six Profitability Metrics
A company's profitability metrics can be calculated anew every time a reporting period ends and financial statements are published. Analysts will compare the company's profitability metrics illustrated here with industry "best in class" standards. They will consider not only the current metrics, but also period-to-period trends in these metrics
With each reporting period, moreover, company management will focus attention on profitability metrics—especially the three margins (gross margin, operating margin, and profit margin on sales). Margins are especially important to management because margins are central to the company's business model. Margins in the business model, that is, show exactly where the company expects to make money. Profitability margins describe how well the company is achieving its business plan objectives.
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Profits and Profit Margins
"Bottom line" net income, or net profit on sales is a measure of the company's financial performance for the period, but the income statement contains other performance metrics as well. The difference between net sales revenues and cost of goods sold is called Gross profit, for instance, while the net income from operations—before taxes and before gains and losses from financial and extraordinary items—is called operating income (or operating profits).
All three of the profit lines from the income statement (gross profit, operating profit, and net profit) can also be expressed as a percentage of net sales, that is, as margins. Gross profit, for instance is gross profit divided by net sales (see the table immediately below. Examples in the table use figures from the sample income statement below):
1. Gross Margin / Gross Profit
Gross profit is an accounting term for Net sales revenues minus the direct costs of producing the goods and services sold (these direct costs may be called cost of goods sold for a company that manufactures products, cost of services for a company that sells services, or sometimes cost of sales for a company that does both). Gross margin is a ratio made of Gross profits divided by Net sales revenues. The Gross margin is often expressed as a percentage of Net sales revenues. Gross margin is thus the profit margin reported before the indirect and general costs of doing business are deducted.
From the sample income statement below:
Net sales revenues: $32,983,000
Cost of goods sold: $10,940
Gross profit
= Net sales revenues – Cost of goods sold
= $32,983,000 – $22,043,000
= $10,940,000
Gross Margin
= Gross profit / Net sales revenues
= $10,940,000 / $32,983,000
= 33.2%
A gross margin computed from income statement figures shows the period's gross margin for the company, of course, but management will also be interested in the gross margins for individual product lines and individual products and services. Calculating individual product gross margins requires information not usually available in the publicly reported financial statements, that is, individual product sales revenues and individual prodcut direct costs.
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2. Operating Margin / Operating Profit
Operating profit is reported income after revenues and expenses for the company's normal operating business have been subtracted, but before factoring in the contributions of financial income, financial expenses, extraordinary items, and taxes. (If the company's business is financial services, however, then financial income and financial expenses do contribute to operating profit, because in that case they do represent the company's normal business). Operating profit expressed as a percentage of Net sales revenues is referred to as Operating margin.
From the sample income statement below:
Net sales revenues: $32,983,000
Cost of goods sold: $22,043,000
All other operating expenses: $7,810,000
Operating profit
= Net sales revenues – Cost of goods sold – Operating expenses
= $32,983,000 – $22,043,000 – $7,810,000
= $3,130,000
Operating Margin
= Operating profit / Net sales revenues
= $3,130,000 / $32,983,000
= 9.2%
Operating profit and operating margin thus show what the company earned (before taxes) from its normal operating business.
Analysts will often compare a company's operating profit margin with its net profit margin on sales (next section), especially after a period when the company experienced significant gains or losses classified as "extraordinary." A company that must reduce employee headcount substantially, for instance, normally incurs a large extraordinary expense for this action (for severance packages, outplacement costs, and other expenses that go with laying off employees). The large extraordinary expense will impact (lower) the profit margin on sales (the "bottom line"), but will not impact operating profit margin. it is possible in such cases to show a positive operating profit, but a net loss for "bottom line" net profit.
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3. Net Profit on Sales / Profit Margin
Net profit (or net profit on sales, or the "bottom line") is the company's reported income after taxes, after normal operating revenues and expenses, after extraordinary items, and after financial income have been considered. Net profit will increase owner value of the company by adding to retained earnings, or by going to shareholders as dividends, or by both actions. Net profit expressed as a percentage of Net sales revenues is the company's profit margin.
From the sample income statement below:
Net sales revenues: $32,983,000
Net expenses:
Cost of goods sold: $22,043,000
Operating expenses: $7,810,000
Net financial expense: $393,000
Net taxes: $958,000
Other net gains:
Net grain from extraordinary item: $347,000 gain
Net profit
= Net sales revenues – Total expenses + Total other gains
= $32,983,000 – $31,204,000 + $347,000
= $2,126,000
Profit margin
= Net profit / Net sales revenues
= $2,126,000 / $32,983,000
= 6.4%
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Profitability Metrics With an Investment Viewpoint
The remaining three profitability metrics take an "investment viewpoint:," making a more direct comparison of owner investment costs with owner investment returns.
4. Return on Total Assets (ROA)
The return on total assets, or return on assets (ROA) metric is sometimes also called "Return on Investment," or ROI for the company (this ROI should not be confused with the cash flow return on investment, or simple ROI which compares investment costs to investment returns for a single action or investment).
From a given income statement and balance sheet, return on total assets can be calculated in either of two ways with the same result.
ROA Method 1: Return on total assets can be derived from Net profit on sales (from the income statement) and Total assets (from the balance sheet). From the sample financial statements below:
Net profit on sales: $2,126,000
Total assets: $22,075,000
Return on total assets
= Net profit on sales / Total assets
= $2,126,000 / $22,075,000
= 9.6%
ROA Method 2: ROA can also be calculated by multiplying the Profit margin on sales (illustrated above) by total asset turnover (illustrated on in this encyclopedia as an activity and efficiency metric). This method for deriving ROA, incidentally, is the final output of the DuPont System of analysis (which also designates the ROA metric as "Return on Investment" for the company).
From the sample income statement and balance sheet below:
Net sales revenues = $32,983,000
Net profit = $2,126,000
Total assets = $22,075,000
Profit margin
= Net profit / Net sales revenues
= $2,126,000 / $32,983,000
= 6.4%
Total asset turnover
= Net sales revenues / Total assets
= $32,983,000 / $22,075,000
= 1.49 total asset turns / year
Return on total assets
= (Profit Margin on sales) x (total asset turnover)
= 6.4% x 1.49
= 9.6%
Return on assets is thus an indicator of "what the company earns" with "what it has to work with". Generally, higher ROA results are preferred to lower ROA figures. Not surprisingly, however, companies in asset-intensive industries (e.g., transportation, construction, or heavy manufacturing) tend to have low ROA figures, whereas companies in industries that do not require such an extensive asset base (possibly financial services or consulting)normally have much higher ROA figures.
In any case, analysts and investors evaluating ROA figures, will compare the company's ROA to standard ROA levels for the specific industry; they will also pay attention to year-to-year changes in a company's ROA.
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5. Return on Equity (ROE) / Return on Owners Investment /
Return on Net Worth / Return on Common Equity
Some analysts and investors consider return on equity (ROE) the most important of the profitability metrics because it compares the company's returns (Net profit) directly to the value of the company's equities—what the company owns outright (i.e., net profit is compared to what the shareholders/owners own outright). Others, however, reserve the "most important" distinction for the earnings per share (EPS) metric in the next section.
Reflecting other commonly used names for shareholder equity, the ROE metric is also called return on owners investment or return on net worth.
Two approaches to computing ROE are in common use:
- Some analysts and investors prefer to calculate ROE using total equities from the balance sheet and net profit from the income statement. This approach is illustrated below as "Simple ROE"
- Others, however, prefer to remove the contribution of preferred share dividends and preferred share equities from the calculation. This is because owners of preferred shares have precedence over owners of common shares both in the payment of dividends and in payouts in the event of liquidation. Preferred ownership thus represents funds that are not and would not be available to common stock owners. This approach to return on equity is illustrated below as return on common equity.
From the sample income statement, balance sheet, and statement of retained earnings below::
Net profit on sales: $2,126,000
Total stockholders equities: $13,137,000
Common stock equities:
= Total Stockholders equities –preferred share contributed capital:
= $13,137,000 – $3,798,000
= $9,339
Preferred share dividends: $33,000
(Simple) Return on equity (ROE)
= Net profit / Total stockholders equities
= $2,126,000 / $13,137,000
= 16.2%
Return on Common Equity
= (Net profit − Preferred dividends) / Common stockholders equities
= ($2,126,000 – $33,000) / $9,339
= 22.4%
ROE and return on common equity show directly how the company's earnings compare to the owners investment (shareholders investment), whereas ROA (previous section) shows how earnings compare to the total owners investments plus any asset investments made with borrowed funds.
Because earnings (profits) come from both owner investments (equities) and assets funded by lenders (liabilities), the ROE metric is sensitive to leverage effects, whereas ROA is much less sensitive to leverage (ROA is based on the total asset figure and pays no attention to the source of funds for assets).
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6. Earnings per Share
Earnings per share (EPS) is viewed by some analysts and investors as the most important of the profitability metrics, while others designate return on equity (previous section) as "most important." In any case, EPS shows directly the returns (earnings, or profits) delivered by the company for each outstanding share of common stock. Note that EPS is the "E" in an equally important valuation metric, the Price/Earnings ratio (or P/E ratio).
Earnings per share always refers to earnings per outstanding share of common stock. Preferred shares are excluded from the calculation for the same reason that preferred shareholder equity is sometimes excluded from the ROE calculation (previous section): owners of preferred shares have precedence over owners of common shares both in the payment of dividends and in payouts in the event of liquidation. Preferred ownership thus represents funds that are not and would not be available to common stock owners. To complete the exclusion of preferred share impact on the EPS metric, the earnings figure in the EPS calculation is Net profits less preferred share dividends.
From the sample income statement and the statement of retained earnings below:
Net profit on sales: $2,126,000
Preferred share dividends: $33,000
From other information in the company's annual report:
Average common shares outstanding for the year: 800,050 shares
Earnings per share
= (Net profit – Preferred share dividends) / Avg common shares outstanding
= ($2,126,000 – $33,000) / 800,050
= $2.62 / share
Investors and potential investors get a rough idea of what they can expect from the company in terms of dividends by considering the earnings per share (EPS) figure, along with the company's history of dividend payment.
Also, as one of the two components of the valuation metric, price/earnings ratio, EPS plays a key role in showing how much confidence investors have in the future earnings growth of the company. A high P/E ratio indicates high confidence in future earnings growth.
Near the end of each accounting period, before financial results are announced, analysts predict EPS for publicly traded companies (sometimes the companies themselves also set expectations for EPS). When the actual EPS results fall short of the expected EPS values, however, share prices are likely to suffer.
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Sample Income Statement
Some of the data for the profitability metrics above were taken from this example Income Statement.
Grande Corporation Gross sales revenues.................33,329 Gross profit.................................10,940 Operating expenses Operating income before taxes............... 3,130 Financial revenue & expenses Income before tax & extraordinary items..... 2,737 Extraordinary items Net Income (Profit).......................... 2,126 |
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Sample Balance Sheet
Some of the data for the profitability metrics above were taken from this example Balance Sheet.
Grande Corporation Assets Liabilities Owners Equity |
For a complete introduction to financial metrics, including a working set of interrelated financial statements and over 100 financial metrics derived from them, see Financial Metrics Pro.
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Sample Statement of Retained Earnings
Some of the data for the profitability metrics above were taken from this example Statement of Retained Earnings.
Grande Corporation Figures in 1,000s Beginning balance, |
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