Profitability Ratios: Is your Company Profitable?

This blog addresses the usage and importance of Profitability ratios while analysing a company's annual report.

What is Profitability? Why it is important to see the profitability of a business. And is it the same as profit?

As an investor you should be interested in profits of a company as companies pay dividends from their profit only but, simply looking at net profit would not give you a clear picture about a company’s overall profitability and might result in low returns in future.

Profit and profitability are often confused with each other but profit is the absolute output of money whereas profitability is the output in relation to the size and operations of the business.

Let us understand why profitability is important with an example: -

Here are two companies “A” and “B” with the same profit but, can you see something fishy? Yes! The net profit is the same but, when we compare it with sales it is 1 % for “A” and 10% for “B”. In this case, the Company “B” is clearly the better option to invest in because of its ability to utilise available resources as compared to “A”.

Still, confused? Suppose in the next year sales increased by “100” for each company. what will be the effects on both companies?

Net profit margin being the same if we increase the sales by 100 units. The net profit of Company “B” got doubled whereas, company A’s profits increased by 10% only.

The profitability Ratios explained with case of “Dixon India Limited”

From the above example, we can see that profit alone can give some deceitful information for investors in the long run. So we need to see profit margins at different levels, along with that we should see returns by some key metrics. These are also known as profitability ratios, let us look at them one by one with an example of a real company “Dixon India limited”.

Profit margins

We measure a company’s ability to generate returns at different levels to understand its profitability completely. There are three key metrics, let us look at them one-by-one.

Note : - The actual amount may differ because some extraordinary items were left off.

1) Gross profit margin - After subtracting the cost associated with procuring, manufacturing and selling of goods also known as the cost of goods sold from revenue of the company we get gross profit. And to calculate gross profit margin formula is (Gross profit/Revenue * 100).

Why it is important - It shows a company’s ability to manage the cost related to manufacturing, procurement and selling of goods. In Dixon’s case we can see that the revenues have increased by 50% approximately but the gross margins have decreased a little. This is because the cost of goods sold have also gone up and this means that the company has increased their resources but with the efficiency have decreased a little.

Gross Profit Margin = Gross Profit/Revenue * 100

2) Operating profit margin - Gross profit deduct only the cost associated with procuring, manufacturing and selling of goods whereas operating profit is calculated after deducting all the expenses related to business operations of a company. In Dixon’s case, the operating expenses are employee-related, D&A and other expenses.

Importance of operating profit - It shows the company’s strength to take out profits with available resources as in this case the operating margins have improved from the previous year it is a good sign and we can see the operating profits of other companies to decide what is best for us.

Operating Profit Margin = Operating Profit/Revenue * 100

3) Net Profit Margin - After subtracting all the expenses including tax and finance cost from operating profit, we come to net profit which is the bottom line of the company’s profitability.

Importance of net profit - Net profit shows the efficiency and effectiveness of the management in generating revenue and controlling the expenses related manufacturing, operations and tax. Dixon’s net profit margin has increased from 1.94% in 2019 to 2.62% in the year 2020, It shows the company is going in the right direction.

Net Profit Margin = Net Profit/Revenue * 100

Return Ratios

Alongside profit, the returns are also important to assess as they describe a company’s ability to efficiently generate returns for the shareholders. There are different types of metrics used to evaluate the returns. Here we will discuss Return on Assets, Return on Equity and Return on capital Invested to better understand the actual returns.

1)Return on assets- The return on assets or ROA is a metric used by analysts to determine how efficiently a company is utilising its assets to generate returns. or we can say that it is the percentage of earnings related to the total average assets of the company.

The average total assets of Dixon technologies is “159483.14” and the net income for the current year  is “12004.67”. After calculation the ROA is 7.52%.

Importance of ROA - We can compare the ROA of Dixon technologies with the companies within the same industry to compare the performance.

ROA = Net Income / (Assets of previous year + Assets of current year/2)

2) Return on Equity - As compared to ROA, the ROE represents a company's ability to efficiently use its Shareholders’ Equity in generating the net income whereas, the ROA takes debt and equity both into accounts. It is calculated as net income divided by average shareholders equity.

The average total shareholders equity of Dixon technologies is “45,977.51” and the net income for current year is “12004.67”. So after calculations the ROE is 26.1%..

Importance of ROE - As investors we should understand how much the company is generating from the equity investment in the company. and we can also compare it with similar companies to make a decision whether to invest or not.

ROE = Net Income / (Shareholders equity of previous year + current year/2)

3) Return on capital employed: - This ratio shows a company’s ability to efficiently use its capital employed (Total assets- current liabilities). to generate return in the long run. It takes EBIT(Profit before tax + interest expense) as a measure to show the operational efficiency as EBIT is a close measure to operating profit.

In Dixon’s case the EBIT for current year is “19173.55” and the capital employed is “78512.59” and after calculating we get 24.42% ROCE for Dixon technologies.

Conclusion

Although, the profits of Dixon Technologies (India) Limited has increased around 50% but, the gross profits have declined slightly, but because of good efficiency of the management and ability to handle business operations we see an increase in operating profit margin. Which later resulted in an overall increase in net profit. Apart from that the company is generating healthy returns when looked via, return ratios.

Note: - To have a better understanding of a company’s performance we need to see the trend in profitability of the company and we should compare similar companies to opt the best available option in the industry.