MATRIX OF PROFITABILITY RATIOS

MATRIX OF PROFITABILITY RATIOS 

SR. NO	PROFITABILITY RATIOS	DESCRIPTION	EXPRESSION	IMPACT	BASED ON
1.	GROSS MARGIN	IT EXPRESSES THE RELATIONSHIP BETWEEN GROSS PROFIT AND SALES REVENUE. IT IS A MEASURE OF HOW WELL EACH RUPEE OF A COMPANY'S REVENUE IS UTILIZED TO COVER THE COSTS OF GOODS SOLD.	GROSS PROFIT / NET SALES	COMPANIES WITH HIGHER GROSS MARGIN PERCENTAGE, THE MORE THE COMPANY RETAINS ON EACH RUPEE OF SALES TO SERVICE ITS OTHER COSTS & OBLIGATIONS.	GROSS PROFIT & NET SALES
2.	OPERATING MARGIN	MEASURES A COMPANY'S PRICING STRATEGY AND OPERATING EFFICIENCY. OPERATING MARGIN GIVES AN IDEA OF HOW MUCH A COMPANY MAKES (BEFORE INTEREST AND TAXES) ON EACH RUPEE OF SALES.	OPERATING INCOME / NET SALES	A HIGHER OPERATING MARGIN MEANS THAT THE COMPANY HAS LESS FINANCIAL RISK.	OPERATING INCOME & NET SALES
3.	PROFIT MARGIN	IT IS AN INDICATOR OF A COMPANY'S PRICING STRATEGIES AND HOW WELL IT CONTROLS COSTS.	NET PROFIT (AFTER TAX) / SALES	A HIGHER PROFIT MARGIN INDICATES A MORE PROFITABLE COMPANY THAT HAS BETTER CONTROL OVER ITS COSTS COMPARED TO ITS COMPETITORS. IT MEASURES HOW MUCH OUT OF EVERY RUPEE OF SALES A COMPANY ACTUALLY KEEPS IN EARNINGS.	NET PROFIT & SALES
4.	RETURN ON EQUITY (ROE)	MEASURES THE RATE OF RETURN ON THE OWNERSHIP INTEREST (SHAREHOLDERS' EQUITY) OF THE COMMON  OWNERS. IT MEASURES A FIRM'S EFFICIENCY AT GENERATING PROFITS FROM EVERY UNIT OF SHAREHOLDERS' EQUITY (ALSO KNOWN AS NET ASSETS OR ASSETS MINUS LIABILITIES).	NET PROFIT (AFTER TAX) / SHAREHOLDER'S EQUITY	RETURN ON EQUITY MEASURES A CORPORATION'S PROFITABILITY BY REVEALING HOW MUCH PROFIT A COMPANY GENERATES WITH THE MONEY SHAREHOLDERS HAVE INVESTED.	NET PROFIT & SHAREHOLDER’S EQUITY OR “SHARE CAPITAL", "NET WORTH" OR "STOCKHOLDERS' EQUITY" OR SHAREHOLDER'S FUND".
5.	RETURN ON INVESTMENT (ROI)	IS THE RATIO OF MONEY GAINED OR LOST ON AN INVESTMENT RELATIVE TO THE AMOUNT OF MONEY INVESTED.	NET PROFIT (AFTER TAX) / INVESTMENT	RETURN ON INVESTMENT EVALUTES THE EFFIENCY OF AN INVESTMENT, MEANS HOW MUCH COMPANY IS GENERATING RETURN ON INVESTMENT.	NET PROFIT (AFTER TAX) AND INVESTMENT
6.	RETURN ON ASSETS (ROA)	RETURN ON ASSETS IS A TEST OF CAPITAL UTILIZATION THAT IS HOW MUCH PROFIT (AFTER INTEREST AND INCOME TAX) A BUSINESS EARNED ON THE TOTAL CAPITAL USED TO MAKE THAT PROFIT.	NET PROFIT (AFTER TAX) / TOTAL ASSETS	IT TELLS WHAT THE COMPANY CAN DO WITH WHAT IT HAS, I.E. HOW MANY RUPEES OF EARNINGS THEY DERIVE FROM EACH RUPEE OF ASSETS THEY CONTROL. IT'S A USEFUL NUMBER FOR COMPARING COMPETING COMPANIES IN THE SAME INDUSTRY.	NET PROFIT (AFTER TAX) AND TOTAL ASSETS
7.	RETURN ON NET ASSTES (RONA)	THE RETURN ON NET ASSETS MEASURES HOW EFFICIENTLY A COMPANY IS USING ITS NET ASSETS (ITS FIXED ASSETS AND NET WORKING INCOME) IN ORDER TO MAKE A PROFIT.	NET PROFIT (AFTER TAX) / FIXED ASSETS + WORKING CAPITAL	THE HIGHER THE RATIO IS, THE BETTER THE COMPANY'S PERFORMANCE IS THOUGHT TO BE.	NET PROFIT (AFTER TAX), FIXED ASSETS AND WORKING CAPITAL

Profitability ratios - Return on Net Assets

Return on Net Assets (RONA) is a measure of financial performance of a company which takes the use of assets into account. 

Note:- The return on Net Assets measures how efficiently a company is using its net assets (its fixed assets and net working income) in order to make a profit. The higher the ratio is, the better the company's performance is thought to be.

Return on Net Assets = Net Profit (After Tax) / Fixed Assets + Working Capital

ILLUSTRATION:-

There is an unaudited financial results for the quarter / half year ended 30, Sept 2010 and Balance Sheet of  BHEL Ltd. :-

From the above information we have following details:-

Net Profit (After Tax) = 11423

Fixed Assets = 41159

Working Capital or Net Current Assets = 120825

Return on Net Assets = Net Profit (After Tax) / Fixed Assets + Working Capital

So, Return on Net Assets = 11423 / 41159 + 120825 = .070 or 7%.

Analysis:-

Return on Net Assets is .070 means, Company is generating Rs. .070 on its every unit of Net Assets or Return is 7% on its Net Assets.

Profitability ratios - Return on Assets

Return On Assets (or ROA for short) is an indicator informing the user about how profitable a company is relative to its total assets. It tells the user how effective a business has been at putting its assets to work.

In other words, the ROA is a test of capital utilization, that is how much profit (after interest and income tax) a business earned on the total capital used to make that profit.

Note :- This number tells that what the company can do with what it has ,i.e. how many rupees of earnings they derive from each rupees of assets they control. It's a useful number for comparing competing companies in the same industry.

Return on Assets = Net Profit (After Tax) / Total Assets

ILLUSTRATION:-

There is unaudited financial results for the quarter/half year ended 30, Sept 2010 and Balance Sheet also of NTPC Ltd.:-

From the above the information we have following details:-

Net profit (After Tax) = 210738

Total Assets = 11918839 (Fixed Assets + Investments + Current Assets, Loans & Advances + Deferred Expenses)

Return on Assets = Net Profit (After Tax) / Total Assets

So, Return on Assets = 210738 / 11918839 = .017 or 1.7%

Analysis:-

Return on Assets is .017 means, Company is generating Rs. .017 earnings from its every rupees of its assets they control.

Profitability ratios - Return on Investment

Rate of Return (ROR), also known as Return on Investment (ROI), Rate of Profit or sometimes just Return, is the ratio of money gained or lost (whether realized or unrealized) on an investment relative to the amount of money invested. The amount of money gained or lost may be referred to as interest, profit/loss, gain/loss, or net income/loss. The money invested may be referred to as the asset, capital, principle, or the cost basis of the investment. ROI is usually expressed as a percentage rather than a fraction.

Return on Investment = Net Income or Net Profit (after Tax) / Investment

or,

Return on Investment = Net Income / Book Value of Investment

or,

Return on Investment = Net Income / Cost of Investment 

Note :- Return on Investment evaluates the efficiency of an investment, means how much Company is generating return on its investment.

ILLUSTRATION:


There is unaudited financial results for the quarter/half year ended 30, Sept 2010 and Balance Sheet also:

From the above information we have following details:-

Net Profit After Tax for 30 Sept 2010 = 61.87

Investment for 30 Sept 2010 = 13082.34 (Fixed Assets + Investment + Current Assets Loans & Advances + Unamortized Expenditure) 

Return on Investment = Net Profit After Tax / Investment

So, Return on Investment = 61.87 / 30175.55 = .0047 or .47%

Analysis:-

Return on Investment is .0047 means Company is generating Rs. .0047 or .47 % from its every unit of its investment. 

Profitability Ratios - Return on Equity

Return on Equity (ROE) measures the rate of return on the ownership interest (shareholders' equity) of the common stock owners. It measures a firm's efficiency at generating profits from every unit of shareholders' equity (also known as net assets or assets minus liabilities). ROE shows how well a company uses investment funds to generate earnings growth.

Return on Equity = Net Profit (after Tax) / Shareholder's Equity

Shareholder's Equity :-A firm's total assets minus its total liabilities. Equivalently, it is share capital plus retained earnings minus treasury shares. Shareholders' equity represents the amount by which a company is financed through common and preferred shares. 

Also known as "share capital", "net worth" or "stockholders' equity" or Shareholder's Fund".

Note:-  Return on Equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.

Illustration :-

This is the Balance Sheet of Reliance Industries Limited as at 30 Sept 2010.

From the above Balance Sheet we have relevant information 

Shareholder's fund or Shareholder's Equity = Rs. 1,45,740 cr. (Capital + Share Application Money + Reserves & Surplus) or {(Total Assets = Fixed Assets + Investment + Current Assets, Loans & Advances) - (Total Liabilities = Loan Funds + Deferred Tax Liability/(Assets) + Current Liabilities & Provisions)}

From the above key highlights we have Net Profit (after Tax) as at 30 Sept 2010 


Net Profit (after Tax) = Rs. 4,923 cr.


So,
Shareholder's Equity = Rs. 1,45,740 cr.
Net Profit (after Tax) = Rs. 4,923 cr


Return on Equity =  Net Profit (after Tax) / Shareholder's Equity


Return on Equity = 4923 / 145740 = .0337 or 3.37%


Analysis :-


So, Return on Equity is .0337 means Company generates Rs. 0.0337 profit from every unit of Shareholder's Equity or 3.37% profit with money shareholders invested.

Profitability ratios - Profit Margin

Profit margin, Net margin, Net profit margin or Net profit ratio all refer to a measure of profitability. Profit margin is an indicator of a company's pricing strategies and how well it controls costs. Differences in competitive strategy and product mix cause the profit margin to vary among different companies.

Profit Margin = Net Profit (after tax) / Sales

Note :- A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. A low profit margin indicates a low margin of safety: higher risk that a decline in sales will erase profits and result in a net loss. It measures how much out of every rupee of sales a company actually keeps in earnings.

Illustration :-

This is the 2nd Quarter & Six Months Results ended 30 September 2010 of "ACKRUTI CITY LIMITED".

From this Result we have relevant information to calculate Profit Margin :-


Net Profit (after Tax) for Six Months ended 30.09.2010 = Rs. 7,174 lac
Sales for Six Months ended 30.09.2010 = Rs. 20,687 lac
So, Profit Margin = Net profit (after Tax) / Sales
Profit Margin = 7174 / 20687 = 0.35


Analysis :-


So, Profit Margin is 0.35 means Company has a Net Income Rs. 0.35 paise of each rupee Sales for Six Months Results ended 30.09.2010.

Profitability Ratios - Operating Margin

Operating Margin is used to measure a company's pricing strategy and operating efficiency. Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt. 


Operating Margin  = Operating Income / Net Sales


Note :- Operating margin gives an idea of how much a company makes (before interest and taxes) on each rupee of sales. If a company's margin is increasing, it is earning more per rupee of sales. The higher the margin, the better. A higher operating margin means that the company has less financial risk.


Illustration :-
This is key highlights of 2nd Quarter Result 2010- 2011 declared by Reliance Industries Limited on 30 Oct 2010.

From this Highlights we have relevant information to calculate Operating Margin:-
Operating Income of Q2 FY11 = Rs. 10,068 cr.
Net Sales of Q2 FY11 = Rs. 57479 cr. (Took from the "Profitability Ratios - Gross Margin" Post)
So, Operating Margin = Operating Income / Net sales
Operating Margin = 10,068 / 57,479 = 0.17
Analysis :- 
So, Operating Margin is 0.17 means Company makes Rs. 0.17 paise (before interest and taxes) on each rupee of sales for Q2 FY11.

Profitability ratios - Gross Margin

Gross margin, gross profit margin or gross profit rate is the difference between the sales and the production costs excluding overhead, payroll, taxation, and interest payments. Gross margin can be defined as the amount of contribution to the business enterprise, after paying for direct-fixed and direct-variable unit costs, required to cover overheads (fixed commitments) and provide a buffer for unknown items. It expresses the relationship between gross profit and sales revenue. It is a measure of how well each rupee of a company's revenue is utilized to cover the costs of goods sold.


It can be expressed as :-
Gross Margin = Net Sales - Cost of Goods Sold + Annual Sales Return
Or,
Gross Margin = Gross Profit / Net Sales
Gross margin Percentage = Revenue - Cost of Goods Sold / Revenue
Note:- Companies with higher gross margins will have more money left over to spend on other business operations, such as research and development or marketing. Companies with the higher Gross Margin Percentage, the more the company retains on each rupee of sales to service its other costs and obligations.


Illustration:-
This is the 2nd Quarter Result of Reliance Industries Limited for session 2010 -2011 

From this Result, we can take the relevant information to calculate the Gross Margin :-
Gross Profit for 2nd Quarter 2010 =  Rs. 6149 cr.
Net Sales for 2nd Quarter 2010 =  Rs. 57479 cr
So, Gross Margin = Gross Profit / Net Sales
Gross Margin = 6149 / 57479 = 0.10


Analysis:-


So, Gross Margin is 0.10 means for every rupee generated in sales, the company has Rs. 0.10 paise left over to cover basic operating cost & Profit for 2nd Quarter 2010 -2011. 

Tools of Fundamental Analysis

Financial Ratios are the main tool of fundamental Analysis. It includes the following ratios :-

1. Profitability Ratio 
2. Liquidity Ratio
3. Activity Ratio or Efficiency Ratio
4. Debt Ratio
5. Market ratio

1. Profitability Ratio :- Profitability ratio measures the company's use of its assets and control of its expenses to generate an acceptable rate of return. Company's Profitability can be measure on the basis of following factors:-

• Gross Margin
• Operating Margin
• Profit Margin
• Return on Equity
• Return on Investment
• Return on Assets
• Return on Net Assets

 Liquidity Ratio :- Liquidity Ratios measures the availability of cash to pay debt. Company's liquidity can be measure on the basis of following factors :-

• Current Ratio
• Quick Ratio
• Cash Ratio 
• Operation Cash Flow Ratio

Activity Ratio :- Activity Ratio measures how quickly a firm converts non-cash assets to cash assets or measures the effectiveness of the firms use of resources. Company's effectiveness can be measure on the basis of following factors :-

• Average Collection Period
• Daily Sales Outstanding Ratio
• Assets Turnover
• Stock Turnover Ratio
• Receivables Turnover Ratio
• Cash Conversion Cycle

 Debt Ratio :- Debt ratios measure the firm's ability to repay long-term debt. Debt ratios measure financial leverage. Company's Debt Ratio can be measure on the basis of following factor :-

• Debt Ratio
• Debt to Equity Ratio

Market Ratio :- Market ratios measure investor response to owning a company's stock and also the cost of issuing stock. Company's Market factor can be measure on the basis of following factor :-

• Earning Per Share
• Payout Ratio
• P/E Ratio
• Dividend Yield 
• Price/Cash Flow Ratio
• Price to Book Value Ratio
• Price/Sales Ratio

So we saw the overview of different types of ratios which is used to measure the Company's Profitability, Liquidity, Efficiency, Debt & Market factor. From the next post we will see individually each and how these are helpful to analyze the stock fundamentally.

Factors of Fundamental Analysis

A company is to be analyzed on fundamentle basis on the basis of following factors :-

• Profitability :- Company's ability to income and sustain growth in both short-term and long-term. A company's degree of profitability is usually based on theincome statement, which reports on the company's results of operations.
• *Solvency :- Company's ability to pay its obligation to creditors and other third parties in the long-term.
• *Liquidity :- Company's ability to maintain positive cash flow, while satisfying immediate obligations.
• Stability :- Company's  ability to remain in business in the long run, without having to sustain significant losses in the conduct of its business. Assessing a company's stability requires the use of both the income statement and the balance sheet, as well as other financial and non-financial indicators.

*Both 2 and 3 are based on the company's balance sheet, which indicates the financial condition of a business as of a given point in time.

Fundamental Analysis of Stock

Fundamental analysis is a stock valuation method that uses financial and economic analysis to predict the movement of stock prices.

The fundamental information that is analyzed can include a company's financial reports, and non-financial information such as estimates of the growth of demand for competing products, industry comparisons, and economy-wide changes.

Main Strategy

To a fundamentalist, the market price of a stock tends to move towards its intrinsic value. If the intrinsic value of a stock is above the current market price, the investor would purchase the stock, and if the intrinsic value of a stock was below the market price, the investor would sell the stock.
To start a fundamentalist makes an examination of the current and future overall health of the economy as a whole. In this step you should attempt to determine the direction and level of interest rates.
After you analyzed the overall economy then analyze firms individually. You should analyze factors that give the firm a competitive advantage in its sector such as management experience, history of performance, growth potential, low cost producer, and etc.

About Fundamental Analysis

Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and management. When analyzing a stock, futures contract, or currency using fundamental analysis there are two basic approaches one can use; bottom up analysis and top down analysis.

Fundamental analysis is performed on historical and present data, but with the goal of making financial forecasts. There are several possible objectives:

• to conduct a company stock valuation and predict its probable price evolution,
• to make a projection on its business performance,
• to evaluate its management and make internal business decisions,
• to calculate its credit risk

"Fundamental Analysis tells us which stock to choose"