Revenue gains for companies are great, but they may not matter much if the company spends all of that revenue on its expenses. Investors use profitability ratios to better understand how companies spend money and learn about ways they can improve.
Types of profitability ratios
The profitability of a company can be measured by its gross margin, operating margin, net margin, and by the returns it achieves on its assets and shareholder equity.
A company's gross margin, as a percent, equals 100 times its gross profit divided by its revenue. A company's gross profit equals its revenue minus cost of goods sold (COGS). If a company has revenue of $100 million and COGS of $90 million, then its gross profit is $10 million and its gross margin is 10%.
A company's operating margin equals 100 times its operating profit divided by its revenue. A company's operating profit equals its gross profit minus fixed expenses such as rent, research and development, and marketing. If the same company has fixed costs of $5 million, then its operating profit is $5 million and its operating margin is 5%.
A company's net margin equals 100 times its net income divided by its revenue. A company's net income equals its operating profit minus all non-operating expenses such as interest expenses and taxes. A company with revenue of $100 million, operating profit of $5 million, and $1 million of non-operating expenses has a net margin of 4%.
Return on assets
A company's return on assets, as a percentage, is equal to 100 times a company's net income divided by the asset value on its balance sheet. A company with net income of $4 million and assets worth $80 million has a return on assets of 5%.
Return on equity
A company's return on equity equals 100 times a company's net income divided by the shareholder equity value on its balance sheet. A company with net income of $4 million and $26.6 million of shareholder equity has a return on equity of 15%.
How to interpret profitability ratios
You can not only compute and analyze current profitability ratios, but you can also compare a company's current values to historical numbers and industry averages.
If a company has a high gross margin, then its ability to charge premium prices is high or its direct costs are low, making it well- positioned to succeed in the market. If a company has a low gross margin, it could have weak pricing power or high direct costs. The company's mix of products could also be changing, with the newer product having lower gross margins.
If a company's gross margin is attractive but the operating margin is low, then the company is spending too much money on fixed expenses. Rents may be rising or it may be getting harder in the industry to retain talented employees without paying higher salaries.
A company with a strong net margin manages well both its operating and non-operating expenses. A company with a relatively low net margin due to relatively low net income may be paying interest expenses on debts incurred. Debt on a company's balance sheet isn't necessarily a bad thing, especially if the interest rates are low and the company's cash flows are sufficiently strong to reliably afford the interest payments.
If a company's net margin is declining and the other margins are staying steady, it's probably because taxes or the company's interest expense is going up. Taxes can rise for a variety of reasons, including selling in higher-tax areas or losing the ability to carry forward tax losses from prior years.
Investors calculate return on equity and return on assets to understand how efficiently a company generates profit from its resources. Return on equity indicates the profitability of a company's assets, while return on assets reveals how well a company uses shareholder investments to make money.
Why profitability ratios matter
Investing legend Benjamin Graham famously said, "In the short run the market is a voting machine and in the long run it is a weighing machine." The most profitable companies are best able to increase their stock prices over time.