12.3: Profitability Ratios- Analyzing Operating Activities

Profitability ratios compare various expenses to revenues, and measure how well the assets of a corporation have been used to generate revenue.

Gross Profit Ratio

The gross profit ratio, as introduced briefly in Chapter 6, indicates the percentage of sales revenue that is left to pay operating expenses, creditor interest, and income taxes after deducting cost of goods sold. The ratio is calculated as:

OR

BDCC's gross profit ratios for the three years are:

		(000s)
		2021		2020		2019
Gross profit	(a)	$	700	$	650	$	540
Net sales	(b)	$	3,200	$	2,800	$	2,340
Gross profit ratio	(a/b)	0.2188:1 or 21.88%		0.2321:1 or 23.21%		0.2308:1 or or 23.08%

In other words, for each dollar of sales BDCC has $0.22 of gross profit left to cover operating, interest, and income tax expenses ($0.23 in each of 2020 and 2019). The ratio has not changed significantly from year to year. However, even a small decline in this percentage can affect net income significantly because the gross profit is such a large component of the income statement. Changes in the gross profit ratio should be investigated, as it will impact future financial performance.

Operating Profit Ratio

The operating profit ratio is one measure of relative change in these other expenses. This ratio indicates the percentage of sales revenue left to cover interest and income taxes expenses after deducting cost of goods sold and operating expenses. In other words:

OR

BDCC's operating profit ratio for the 2019, 2020, and 2021 fiscal years is calculated as follows:

		(000s)
		2021		2020		2019
Income from operations	(a)	$	300	$	274	$	204
Net sales	(b)	$	3,200	$	2,800	$	2,340
Operating profit ratio	(a/b)	0.0938:1 or 9.38%		0.0979:1 or 9.79%		0.0872:1 or or 8.72%

For each dollar of sales revenue in 2021, the company had $0.09 left to cover interest and income tax expenses after deducting cost of goods sold and operating expenses. A review of the company's operating expenses (selling, general, and administrative expenses; employee benefits, and depreciation) show that they have all increased. As a result, and despite increasing sales revenue and gross profit, operating income has remained relatively flat. Although it seems reasonable that an increase in operating expenses would follow an increase in sales, the reasons for the operating expense increases should be investigated.

Net Profit Ratio

The net profit ratio is the percentage of sales revenue retained by the company after payment of operating expenses, interest expenses, and income taxes. It is an index of performance that can be used to compare the company to others in the same industry. This ratio is calculated by the following formula:

OR

BDCC's net profit ratios for the three years are calculated as follows:

		(000s)
		2021		2020		2019
Net income	(a)	$	116	$	117	$	112
Net sales	(b)	$	3,200	$	2,800	$	2,340
Net profit ratio	(a/b)	0.0363:1 or 3.63%		0.418:1 or 4.18%		0.0479:1 or or 4.79%

For each $1 of sales in 2021, BDCC earned $0.04 of net income. The net profit ratio has been relatively stable but needs to be compared with industry or competitors' averages for a better perspective.

Recall that revenues are generated from a business's asset holdings. The financial strength and success of a corporation depends on the efficient use of these assets. An analysis of asset investment decisions can be made by calculating several ratios, and is discussed next.

Sales to Total Assets Ratio

Are BDCC's sales adequate in relation to its assets? The calculation of the sales to total assets ratio helps to answer this question by establishing the number of sales dollars earned for each dollar invested in assets. The ratio is calculated as:

OR

BDCC's ratios are calculated as follows:

		(000s)
		2021		2020
Net sales	(a)	$	3,200	$	2,800
Average total assets	(b)	$	2,2997	$	1,764.508
Sales to total assets ratio	(a/b)	1.3919:1 or 139.19%		1.5869:1 or 158.69%

The ratio has decreased from 2020 to 2021. Each $1 of investment in assets in 2020 generated sales of $1.59. In 2021, each $1 of investment in assets generated only $1.39 in sales. Over the same period, BDCC's investment in assets increased. The ratios indicate that the additional assets are not producing revenue as effectively as in the past. It may be too soon to tell whether the increase in assets in 2020 will eventually create greater sales but an investigation is required.

As noted earlier, comparison with industry averages would be useful. A low ratio in relation to other companies in the same industry may indicate an over-investment in or inefficient use of assets by BDCC. On the other hand, a higher ratio in comparison to other companies would be a positive indicator.

Return on Total Assets Ratio (ROA)

The return on total assets ratio or ROA is designed to measure the efficiency with which all of a company's assets are used to produce income from operations. The ratio is calculated as:

OR

Note that expenses needed to finance the company operations are excluded from the calculation, specifically interest and income taxes. This is because all the assets of the company are considered in the ratio's denominator, whether financed by investors or creditors. Average Total Assets are used in the calculation because the amount of assets used likely varies during the year. The use of averages tends to smooth out such fluctuations.

BDCC's returns on total assets for 2020 and 2021 are calculated as follows:

		(000s)
		2021		2020
Income from operations	(a)	$	300	$	274
Average total assets	(b)	$	2,2999	$	1,764.5010
Return on total assets ratio	(a/b)	0.1305:1 or 13.05%		0.1553:1 or 15.53%

The ratios indicate that Big Dog earned $0.13 of income from operations for every $1 of average total assets in 2021, a decrease from $0.16 per $1 in 2020. This downward trend indicates that assets are being used less efficiently. However, it may be that the increased investment in assets has not yet begun to pay off. On the other hand, although sales are increasing, it is possible that future sales volume will not be sufficient to justify the increase in assets. More information about the company's plans and projections would be useful. Recall that ratio analysis promotes the asking of directed questions for the purpose of more informed decision making.

Return on Equity Ratio (ROE)

The return on equity ratio measures the return to shareholders — how much net income was earned for the owners of a business. It is calculated as:

OR

The 2020 and 2021 returns on equity ratios for BDCC are calculated as follows (note that the 2019 ratio is excluded because average equity cannot be calculated since 2018 ending balances are not provided):

		(000s)
		2021		2020
Net income	(a)	$	116	$	117
Average equity	(b)	$	1,21311	$	1,121.5012
Return on equity ratio	(a/b)	0.0956:1 or 9.56%		0.1043:1 or 10.43%

In both years, shareholders earned, on average, $0.10 for every $1 invested in BDCC, or 10%. Industry averages could help with this analysis. For instance, if the industry as a whole earned only a 5% return on equity in 2021, it could be concluded that BDCC performed better than the industry average in terms of return on equity.