Understanding Profitability Ratios And Its Importance On Your Stock Investment
Companies can be evaluated based on financial ratios. A commonly used tool of financial ratios by investment analysts is the profitability ratio. Every business enterprise is concerned about profitability and stock investors in Singapore should be too.
For a new investor, learning these ratios could be daunting at first, but would eventually be very rewarding as you continue on your investment journey. Doing a quantitative analysis when reading the data contained in a company’s financial statement can be protracted, if not confusing. Thus, knowing the key profitability ratios can help you abridge the financial analysis process.
The significance of profitability ratios
Never mind if you’re not an accountant who can juggle the numbers. The most important thing is that you know how these numbers relate to profitability when you are investing in stocks listed on the Singapore Exchange (SGX) or on any other stock market.
- Profitability ratios are tools to measure or gauge a company’s overall efficiency and business performance.
- Externally, creditors and investors are given a clear picture of the business through significant and fathomable ratios.
- Internally, owners, operators, and managers are enabled to make business related concerns such as diversification, expansion, or shake-up that would lead to better profitability.
- In truth, no investor would bet their hard-earned money on a non-earning proposition. Profitability ratios are referred to as the ‘classic’ financial metrics to judge a company’s ability to make profits and be considered a worthy investment.
The Margin and Return Ratios
There are two types of profitability ratios namely, margins and returns. Each type has various ratios that tend to show income generation in relation to a company’s expenses and other material costs incurred during a given time frame.
Gross Profit Margin
Gross profit margin focuses at the cost of goods sold as a percentage of sales. It tells how good a company utilizes and controls its inventory, labor, and other resources to generate profit. This ratio also shows how the costs are passed on to its end users.
To calculate the ratio, divide Gross Profit by Net Sales to get the resulting percentage. A higher the gross profit margin is always favorable for the company. Both items are taken from the company’s profit and loss statement or the income statement.
Operating Profit Margin
Refer to the income statement to see the operating profit or EBIT (earnings before interest and taxes). This ratio looks at EBIT as a percentage of sales. The overall operating efficiency of the company is measured by the operating profit margin.
It incorporates all expenses of regular business operations and activities. Again, lift the EBIT from the income statement then divide it by Net Sales to arrive at the percentage.
Net Profit Margin
The net profit margin is the simplest when it comes to conducting a profitability ratio analysis. The net profit margin measures profitability after all expenses have been paid out, including taxes, interest, and depreciation.
To better explain, if the net profit margin is 5%, it means that 5 cents of every dollar is profit. Computing for the net profit margin is just as simple. You divide the Net Income by Net Sales to get the percentage. Both net income and net sales are presented in the income statement.
Cash Flow Margin
This ratio states the relationship between cash generated from operations vis-a-vis sales. Cash flow is as important as profit in any company. The business needs as much cash to pay suppliers, loan obligations, and even dividends. Investing in new capital assets require cash as well.
The cash flow margin ratio is a good indicator of a firm company’s knack to transform sales into cash. The formula is cash flow from operating cash flows divided by Net Sales to find the percentage. The numerator, which is the cash flow from operating cash flows, is taken from the company’s statement of cash flows. The net sales or the denominator comes from the Income Statement. The higher the cash flow margin percentage, the better it is for the business.
- Return on Assets (ROA) or Return on Investment (ROI)
The Return on Assets ratio measures the company’s efficiency in terms of managing investment in assets and utilizing them to generate profit. It shows the amount of profit earned in relation to the level of investment in total assets. The return on assets ratio is associated with the asset management side of financial ratios.
The ratio is derived by dividing Net Income by the Total Assets. This time the total assets are lifted from the company’s balance sheet while the net income is taken from the income statement. A high ROA ratio is reflective of a company’s effective management of its assets to generate sales.
- Return on Equity (ROE)
Investors regard the ROE ratio as the most important of all the financial ratios. It measures the return on the money invested into the company. Prospective investors anchor their decisions based on the ROE.
The formula to compute for the ROE ratio is Net Income divided by the Stockholder’s Equity. Net income originates from the income statement while the stockholder’s equity emanates from the balance sheet. In general, the higher the percentage shows that investors are getting their money’s worth in the investment.
- Cash Return on Assets
This ratio is used mostly for advanced profitability ratio analysis. It is basically a cash comparison. Since the return on assets is presented on an accrual basis, it is compared to this ratio. Usually, the ratio is used when determining future investments.
You divide the cash flow from operating activities by the total assets to get the percentage. The statement of cash flows is where the numerator is derived while total assets are taken from the balance sheet. Just like the other ratios, a higher percentage is favorable.
There are other relevant financial ratios in the investment process such as liquidity and debt ratios. All are material to see the ‘real’ picture of a company’s merit as an investment option. However, the profitability ratios would be ample aids for the learning investor. Understandably, it takes time to acquire the skills. What’s good is that you’re taking the right steps to be familiar with the art and science behind investing.