Financial Ratio Analysis (Profitability ratios)

First, what are the profitability ratios? ROE, ROA, Gross margin, profit margin, SG&A/sales etc are included here. Most people are familiar with the term return on equity and think it’s the most important ratio. I would say I do prefer ROA (return on asset) since it best captures operations of the firm (not counting financial stocks here). ROE can be viewed simply as ROA multiplied by capital leverage. Therefore if a company can operate well and with a good business model leverage level should not be hard to adjust in order to maximize shareholder’s return. What’s the money that eventually can be allocated to shareholders? The net income, the profit, the bottom line, etc.  Revenue is on top of income statement so it’s called the top line; now you can guess why net income is called bottom line. You see, accounting is really not that hard to understand, is it?:)

How do you calculate these ratios? Well, if you’re not as ‘diligent’ as I am you can just go Morningstar.com to get almost all the ratios you need. Actually I have automated my data collection process so that it will only take me a few minutes to get all the ratios. Of course, the result depends on the accuracy of original data source (yahoo, google). Based on my observations and tests, the data are generally good. There are great benefits for you to calculate these ratios on your own though as the process will familiarize yourself with the company’s statements and get sense of business items involved. Alright, let’s see what is exactly the math for the profitability ratios. 

Hopefully this is where you tell yourself accounting is really just elementary school mathJ. The way to understand the ratios are also intuitive as I see it. For a good company you like to see high return ratios and margins, but want to have small cost/expense ratios. Make sense?

It’s useful to compare across time for one company but it gets complicated when you compare across different companies due to different business operations. For example, companies like Amazon and Walmart are really low margin operators so you shouldn’t compare them with Intel which has rather high margins.  

Now let’s take Amazon as an example to look at ratios listed in the financial ratio analysis framework. The following picture shows the past four years’ profitability ratios.

What do you see there? Gross margin varies just a little bit but you can see significant improvement on profit margin. Since there are not much change on gross margin what is causing the increase of profit margin? As you might know gross margin subtracting operating expense, interest expense, and tax gives you profit margin. Therefore, the expenses I mention here are reduced year by year. SG&A/sales ratios is part of the operating expense and it is trending downward. In summary, considering economic conditions in 2008 and 2009, the company did a great job by increasing profitability. I’ll discuss ROE and ROA later.

BTW, feel free to leave me your feedback and please show your support by click ads on the blog if you don't mind:)