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Why are Financial Ratios Important?

By analyzing investor ratios, stock pickers can seek out winning companies for purchase and eliminate the duds. The major investment ratio categories include profitability, valuation, liquidity, and debt. Profitability ratio analysis explains whether the company is making and keeping more money today than in the past.

Valuation ratios uncover whether the firm seems to be fairly priced or not. Debt ratios uncover a company’s debt levels, and liquidity helps investors understand how much cash is available to run the business.

You might find a growing company that’s increasing profits, but if the firm is selling at an excessive valuation or has excessive debt, then your future profit potential is limited. This article will focus on the most important profitability ratios, why they are important, and how to evaluate them.

I was a portfolio analyst and stock picker. It was fun to dig into the financial statements of public companies and study investor ratios. Profitability ratios show how much of a company’s revenue remains after expenses are paid. Profitability ratios are exciting because, similar to home budgeting, the more money that remains after paying the bills, the more flexibility there is to grow the firm, reinvest in the business, or buy back shares.

Investment Ratio Research Tips

• Compare profitability ratios within the same industry.
• Notice profitability ratio trends. Increasing profitability ratios are best.
• Also study valuation ratios and future growth expectations for a company.

Clearly, the more profitable a company is, the better. But, there’s more to investment ratios than choosing the company with the highest profit margin.

Comparing Financial Ratios Between Companies

When evaluating a stock to purchase, compare the profitability ratios to competitors within the same industry. The reason is because industry profitability ratios vary. A supermarket chain like the Kroger Companies (KR) typically has a 2% to 3% profit margin, while a tech company like Intel (INTC) might have a 20% to 30% profit margin.

If investors didn’t compare investment ratios with competitors within the same industry, they would only buy technology companies and not supermarkets. You can make money investing in all types of growing businesses with sound financial management.

Understanding profitability margins doesn’t mean that you always choose the firm with the highest ratio. Ultimately, you can make money by investing in companies with high or low profitability ratios if the firm’s future growth is strong and you buy shares at a reasonable price.

When performing investment ratio analysis for stock picking, the percentages or profit margins shouldn’t be considered in a vacuum. Understand the industry norms, the historical profitability ratios for the specific company, as well as current valuation, growth potential, and the industry. Then, compare financial ratios between companies within the same industry.

Think of ratio analysis as a tool to determine whether a company is worthy of continued consideration, or if the numbers suggest poor management or weak growth prospects. If a company isn’t profitable, with steady or improving margins, then it’s time to move on to the next stock study candidate.

Following are several investor ratio examples to explore when analyzing individual stocks. These profitability ratios can weed out the less profitable firms from those that are well-managed. These ratios can be found on websites like Yahoo!Finance, MarketWatch, and the company website, within their SEC filings or annual reports.

Review the financial statements to gather the relevant numbers. Oftentimes, the ratios are already calculated.

Types of Profitability Ratios Investors are Interested In

Profitability ratios fall into margin and performance or return categories. These groups of investor ratios can explain a company’s financial health and their performance. Regardless of the type of ratios you analyze, always look at the trends. When analyzing profitability investor ratios, consider the following questions:

• Are company profits increasing?
• Are profitability margins improving?
• How is the firm’s performance in comparison to competing companies and the industry?

Margin Ratios - Gross Profit Margin

Margin ratios measure how efficient businesses are in turning their sales into profits. Gross profit margin is the amount of money left over from revenues after subtracting the cost of goods sold (COGS). This margin is frequently expressed as a percent of sales.

• Gross Profit Margin = Net Sales – COGS / Net Sales.

This figure is usually expressed as a percentage and measures the company's profit before subtracting selling, general, and administrative costs. Higher gross profit margins are better than lower. GPMs that are better than competitors might be a sign of strong management. If this figure is small, or declining, you might want to move on to the next stock study candidate.

Net Profit Margin

Sometimes referred to as net margin, the net profit margin is the relationship between revenues and net profits. It's typically expressed as a percentage. This ratio is more informative than the gross profit margin and shows the percent of profit for every dollar of revenue. This metric is among the most crucial indicators of a company's financial well-being.

• Net Profit Margin = [(Revenue) - (COGS - Operating Expenses - Interest - Taxes)] / Revenue.

Another way to state the Net Profit Margin is Net Income divided by Revenue. The net profit margin is a goldmine of information and identifies:

• Total revenue.
• Additional income including investment income.
• All expenses including COGS and tax payments.
• Debt and interest payments.

Investors can delve into this margin, compare it with previous margins, as well as net profit margins of competitor firms. Investigate expenses and whether they are growing or receding. An increasing net margin is a good sign that a company is handling it's resources well by keeping expenses in check and growing revenues.

Net Profit Margin Example

Assume revenue is $100,000,000 and COGS, Operating Expenses, Interest, and Taxes are $60,000,0000. Then the net profit is $40,000,000. This leaves a healthy 40% profit margin.

Compare that percentage with the company's former profit margins and the net profit margin of competitors. If the percentage is steady or improving, that's a good sign. If it is equal to or better than competitors, that's also positive.

Operating Profit Margin

The operating margin explains how well the company creates profits from it's business before paying taxes and interest. In short, it can indicate how well a company is running is business. The operating profit margin is frequently used by stock analysts and often called EBIT earnings or earnings before interest and taxes.

• Operating Profit Margin = [(Revenue) - (COGS - Operating Expenses)] / Revenue.

Operating margins that go up and down may be a negative sign, along with declining margins. As with other investor ratio examples, if the operating profit margin is lower than the industry average. you might want to look for a better company to invest in.

If costs increase and revenue doesn't, then your operating margin will decline. Watch out for falling profitability ratios and learn whether it might be a one-time event of a persistent trend. The following performance ratios are among the best ratios for investors to uncover how efficiently a company is using it's assets and growing it's equity for shareholders.

Return Ratios

Don't buy a stock before understanding at least these two important financial ratios. The return on assets and return on equity indicate the company's ability to generate returns to its shareholder. A well-managed company should have stable or growing return ratios.

Before buying a stock, you may want to make sure that you're buying shares in a company that has a strong likelihood of providing a good return on your investment.

Return on Equity

This investor ratio calculates how efficiently the company is in using its equity to generate a profit. To easily grasp this concept, imagine you bought a house for $400,000 with a down payment of $80,000. In one year, the value of your home appreciated 10% and was worth $440,000. Your return on equity (or the ownership in your home) is $40,000/$80,000, or 50%.

So even though your home price increased 10%, if you sold your home at the end of one year (excluding transaction costs), you would have your original $80,000 plus the $40,000 that the home increased in value during the year.

The 50% return on equity (ROE) is a very good profit. Since your shares in the company represent an ownership percentage, you want to invest in companies with a high and increasing ROE. To calculate ROE, simply take net income and divide it by total assets.

• Return on Equity = Net income/Shareholders equity.

Like in the margin examples, return on equity varies by industry and company. Higher and increasing ROE is the best.

Return on Assets

The more efficiently a company is run, the greater the profits, all other factors being equal. The ROA explains how much after-tax profit a company makes for each dollar of assets owned. Typically, the lower the percent of profit, per asset, the more assets the firm owns.

Some companies need greater assets to thrive, such as large manufacturing facilities with lots of equipment. While some companies have fewer tangible assets and greater intellectual assets, asset-rich companies typically have lower return on assets. Examples of asset heavy companies include automobile manufacturers, telecommunication services, and railroads. While something like a software company will normally have fewer assets.

• Return on Assets = Net income / Total assets.

Some asset heavy companies can earn strong profits, experience robust growth, and offer sound future returns. Make sure to compare ROA with companies within the same industry. Also, use this ratio in conjunction with other important investment ratios before investing.

Profitability Investor Ratios Wrap up

The profitability investor ratio study is just one type of analysis for fundamental investment researchers. Other categories of ratios to examine include debt, liquidity, growth, and valuation metrics.

When analyzing a stock for purchase, expect to review ten or more companies before finding a stock that is well-managed, growing, and fairly priced. When you find a company with high profitability metrics that is priced lower than it's intrinsic value, according to ratios like the price earnings ratio, you might have a potential winner.