# 5.3: Profitability Ratios

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The __Profitability Ratios__ are popular measures used to evaluate a firm’s returns by relating profits to sales, assets, or equity. Profitability Ratios allow an investor to measure the ability of a firm to earn an adequate return on sales, total assets, equity, and invested capital. As with all financial ratios, the profitability ratios must be compared to a company’s competitors as well as the market as a whole.

In the ratios that follow, we will be using the financial statements for Sprouts Family Market (SFM) that were introduced above. So get out your 99¢ calculator and have the financial statements available. It will also be helpful to have the __chapter 5 formula street__ available. The formula sheet tells you which financial statement or statements we need to consult.

# Net Profit Margin, also known as After-tax Profit Margin

The __Net Profit Margin__, also known as the After-tax Profit Margin, is the rate of profit being earned from earnings after expenses and taxes.

` Net Income Net Profit`

Net Profit Margin **= ** ——————————————— **or ** —————————————

Total Revenue Total Sales

'The Net Profit Margin compares the two most popular entries from the Income Statement, the “top line” Total Sales, also referred to as Total Revenue, and the “bottom line” Net Income, also referred to as Net Profit. The higher the result, the better. But we repeat that we must always compare this result with similar companies because the Net Profit Margin varies greatly from one industry to the next.

Consulting the Income Statement, we see that the Net Income for Sprouts was 261,160 and the Total Revenue was 6,400,000. The Net Profit Margin, therefore, is 4.08%. Is that good? Ah, we don’t know. We need to compare this result with their competitors. What would you expect the Net Profit Margins would be for grocery stores? Would they command higher margins than the stock market as a whole? Or would the fact that there is such tremendous competition in the grocery retail industry result in net profit margins that are depressed when compared to the stock market as a whole? Much more research is needed!

# Gross Margin

The __Gross Margin__ reports the rate of profit being earned from Gross Profit. __Gross Profit__ differs from Net Income (also called Net Profit). Looking carefully at the Income Statement, we can see that Gross Profit is simply the Total Revenue minus the __Cost of Goods Sold__.

` Gross Profit Gross Income`

Gross Margin **= ** ——————————————— **or ** ——————————————

Total Revenue Total Sales

This ratio is not as popular as the Net Profit Margin. However, it can help us compare a company against its competitors. The Gross Margin tells us how efficiently it was able to produce a profit from the goods or services provided by the company. A Gross Margin higher than their competitors demonstrates the company is better adept at being able to earn money from its business activities. As with the Net Profit Margin, it varies greatly from industry to industry.

For Sprouts, we see that their Gross Profit is 2,820,000. Dividing that by the Total Revenue gives us 37.22%. That is typical of most retail outlets. In general, unless it is a very high-end retail outlet with exclusive and expensive items, you can expect that the store will be paying anywhere between 30% and 40% less than the retail prices. On some high-volume items, it is far less. Sure, they only make a few percent on high-volume items such as milk, eggs, and bread. But they sell you milk, eggs, and bread every week, sometimes every few days.

# Operating Margin

The __Operating Margin__ takes the Gross Margin one step further. The Operating Margin uses the __Operating Income__, also called Operating Profit or Income from Operations.

` Operating Income Operating Profit`

Operating Margin **= ** —————————————————— **or ** ——————————————————

Total Revenue Total Sales

The Operating Income starts with the Gross Profit above and then subtracts the overhead expenses such as research and development, sales, administrative, and general expenses. As with the previous two ratios, the higher the better but remember to compare the result with companies in the same industry as the results will vary widely from industry to industry.

The Operating Income for Sprouts is 352,580. Dividing the Operating Income by the Total Revenue gives us an Operating Margin of 5.51%, a number that would need to be compared to their competitors.

# Return on Assets (ROA)

__Return on Assets__ is a measure of how profitable a company is relative to its total assets. It looks at the amount of resources a company needs to support operations and reveals how effective the company is in generating profits from the assets it has available. The previous three ratios only used the Income Statement. The Return on Assets uses both the Income Statement and Balance Sheet.

` Net Income`

Return on Assets **= ** ——————————————

Total Assets

Return on Assets and the next two ratios are very popular ratios. Obviously, the higher the better. For Sprouts, the Net Income of 261,160 divided by the Total Assets of 3,466,000 results in a Return on Assets of 7.53%.

# Return on Equity (ROE)

__Return on Equity__ relates the overall profitability of a company in relation to the shareholders’ equity.

` Net Income`

Return on Equity **= ** ————————————————————————————

Total Stockholders' Equity

Because Return on Equity uses Stockholders’ Equity instead of Total Assets for the denominator, Return on Equity is sensitive to the amount of debt a company is carrying. Specifically, if a company carries a great amount of debt, Return on Equity will be much larger than Return on Assets. This is often referred to as leverage. You will hear investors say, “You are using other people’s money to make your money.” You are using borrowed money as a lever to enhance your profits. Some investors view this positively; others are worried about the possible negative consequences of too much debt. Looking at the data for Sprouts, the Net Income of 261,160 divided by the Total Stockholders’ Equity of 1,050,000 gives a Return on Equity of 24.87% that we would compare with their competitors.

# Return on Invested Capital (ROIC)

__Return on Invested Capital__ measures the overall profitability of a company in relation to both debt and equity.

` Net Income`

Return on Invested Capital **= ** —————————————————————————————————————————————

Long-term Debt + Total Stockholders’ Equity

Return on Invested Capital is used by many long-term investors such as Warren Buffett. However, there are a few different ways of calculating ROIC. We are using the most simplistic version. By using both long-term debt and stockholders’ equity, ROIC measures how well a company is managing all the capital the company needs to earn its profits.

Adding the Long-term Debt of 1,400,000 and the Total Stockholders’ Equity of 1,050,000 gives us a denominator of 2,450,000. Then dividing Net Income of 261,160 by the 2,450,000 denominator gives us a Return on Invested Capital of 10.66% for Sprouts.