Profitability Ratios

Profitabi I it)' ratios are of two types - those showing profitability in relation to sales and those showing profitability in relation to investment. Together, these ratios indicate the firm overall effectiveness of operation.

This ratio tells us the profit of the firm relative to sales, after we deduct the cost of producing the goods. It is a measure of the efficiency of the firm's operations, as well as an indication of how products are priced. Aldine's gross profit margin is significantly above the median of 23.8 percent for the industry, indicating that it is relatively more effective at producing and selling products above cost.

The net profit margin is a measure of the firm's profitability of sales after taking account of all expenses and income taxes. It tells us a firm's net income per dollar of sales. For Aldine, roughly 5 cents out of every sales dollar constitutes after-tax profits. Aldine's net profit margin is above the median net profit margin for the industry, which indicates that it has a higher relative level of "sales profitability" than most other firms in the industry.

By considering both ratios jointly, we are able to gain considerable insight into the operations of the firm. If the gross profit margin is essentially unchanged over a period of several years but the net profit margin has declined over the same period, we know that the cause is either higher selling, general, and administrative (SG&A) expenses relative to sales, or a higher tax rate. On the other hand, if the gross profit margin falls, we know that the cost of producing goods relative to sales has increased. This occurrence, in turn, may be due to lower prices or to lower operating efficiency in relation to volume.

ROI and the Du Pont Approach. In about 1919 the Du Pont Company began to use a particular approach to ratio analysis to evaluate the firm's effectiveness. One variation of this Du Pont approach has special relevance to understanding a firm's return on investment. As shown in Figure 6.4, when we multiply the net profit margin of the firm by the total asset turnover, we obtain the return on investment, or earning power on total assets.

Neither the net profit margin nor the total asset turnover ratio by itself provides an ad equate measure of overall effectiveness. The net profit margin ignores the utilization of asset and the total asset turnover ratio ignores profitability on sales. The return on investment ratio or earning power, resolves these shortcomings. An improvement in the earning power of the firm will result if there is an increase in turnover on assets, an increase in the net profi: margin, or both. Two firms with different net profit margins and total asset turnovers mahave the same earning power. Geraldine Lim's Oriental Grocery, with a net profit margin o: only 2 percent and a total asset turnover of 10, has the same earning power - 20 percent - as the Megawatt Power Supply Company, with a net profit margin of 20 percent and a tota asset turnover of 1. For each firm, every dollar invested in assets returns 20 cents in after-tax profit per year.

This ratio tells us the earning power on shareholders' book value investment, and is frequently used in comparing two or more firms in an industry. A high return on equity often reflects the firm's acceptance of strong investment opportunities and effective expense management. However, if the firm has chosen to employ a level of debt that is high by industry standards, a high ROE might simply be the result of assuming excessive financial risk. Aldine's ROE is below the median return (14.04 percent) for the industry.

This Du Pont approach to ROE helps to explain "why" Aldine's ROE is less than the industry's median ROE. Although Aldine's net profit margin is higher than average and its equity multiplier is about at the industry norm,' its lower-than-average total asset turnover pulls its ROE down below that of the typical firm in the industry. This suggests that Aldine's use of a relatively greater proportion of assets to produce sales than most other firms in the industry is the root cause of its below-average ROE.

With all of the profitability ratios discussed, comparing one company with similar companies and industry standards is extremely valuable. Only by comparisons are we able to judge whether the profitability of a particular company is good or bad, and why. Absolute figures provide some insight, but it is relative performance that is most revealing.