He suggests using these ratios to judge a company’s profitability. For all, the higher the number, the better. They include:
- net profit margin = net profit after tax divided by sales. One way to increase this number is to reduce costs while keeping output the same. Another is to increase sales by raising prices or expanding into new markets or product lines.
- return on assets = net profit after tax divided by total assets. This is a measure of the return on the investment in the company. How does that compare to what someone could have gotten if he had put the money in a CD at the bank? This ratio measures how well the company is managing its assets.
- total asset turnover = sales divided by total assets.
Here are some other ratios that affect profitability:
- inventory turnover = costs of goods sold divided by inventory. The higher the number, the better.
- accounts receivable collection period = accounts receivable divided by (sales/365 days) or sales per day. A company would like it to be zero, but does it at least match the company’s collection period, usually 30 days?
And these ratios can help analyze how a company is financed. A company can sell stock or bonds to raise capital. Debt is generally cheaper than equity.
- debt ratio = total debt/total assets. A lower number is less risky. It will lie between 0 and 1.
- debt/equity ratio = total debt/total equity. This ratio gives the same info as the previous one, but the number is not bounded. Again, a lower number is less risky.
- equity multiplier = total assets/common equity. This tells us the impact of leverage on earnings.
And here’s a very important ratio: return on equity = net earnings (or earnings available to common shareholders) divided by common equity. It establishes the rate of return generated for common stockholders. The higher the number, the better, if it’s consistent through time. Fifteen to 25 percent is typical.
He also says to use this profitability model to see how a company is generating profits. It is useful because it separates return on equity into three components:
- financial leverage (equity multiplier)
- operating efficiency (net profit margin)
- asset utilization (total asset turnover)
Return on equity is a function of all three factors. Return on equity equals net profit margin (or net profits/sales) times total asset turnover (or sales/total assets) times the equity multiplier (or total assets/common equity).