Analysis of profitability

Way to profitability
Way to profitability

Shareholders are interested in profitability. Enough profit would ensure fat dividends beside rise in market value of their shares thereby increasing the capital gain on disposal. Also, the banks study profitability which shows some sort of creditworthiness of a company. Likewise, managers take keen interest in the same figure as it is used for determining their performances. 

To analyze profitability, three main ratios are worked out.  First, gross profit margin which shows raw margin as it covers only production costs.  Second is operating profit margin which includes all manufacturing and non-manufacturing costs except interest.  Third is Net Profit Margin taking into account all costs and expenses.  Ratios from a single statement such as P&L Account may be misleading.  A high net profit margin is not necessarily good sign as it is based on income statement prepared on accrual basis. 

By using data both from P&L account and Balance Sheet, we can calculate efficiency ratios which are more creditable.  Another ratio is in the form of returns obtained either directly or by multiplying two to three ratios. As an example, some data of Packages Ltd is being used. In 2008, the company earned an operating profit of Rs.405 million while its total assets were of Rs.35.03 billion, the returns on Assets (ROA) being 1.16%. Same results can be obtained if we multiply net operating margin (3.31%) with assets turnover (0.35 times).

 

GROSS PROFIT MARGIN

Also called gross margin or raw margin, this is a measure of profitability on the core activity i.e. production.  First, gross profit is determined by deducting cost of sales from sales. Second, the gross profit so determined is divided by the sales and results shown in percentage. If gross margin is 15%, it means that 85% has been consumed in production by way of raw materials, labor and overheads. Of this 15%, the company would have to cover all operating and non-operating expenses leaving net profit margin which could be negative in case of poor performance.

Gross margin differ from industry to industry.  In case of Packages Ltd, it was 13.3% in 2007 which went to 7.7% in 2008 because of rising costs of production.

OPERATING PROFIT MARGIN

Operating expenses consist of selling and administrative expenses (S&A).  These non-manufacturing expenses but essential for sale of goods. In 2008, these expenses were Rs.874 million, up from Rs.588 million in the previous year.

The rise of 48% in S&A expenses further depressed the operating profit margin which nose dived to 0.6% in 2008 from the previous year level of 6.8%.

NET PROFIT MARGIN

Net profit is the residual profit after meeting all costs and expenses.  Call bottom-line, this shows the end result of the annual operations.  Packages Ltd has incurred a loss in 2008 as a result of which the Net Profit Margin is negative.  It may be stated that it was very high in 2007 mainly due to other income resulting from gain on sales of investment.

Turnover ratio

Turnover ratios, sometime called Efficiency Ratios, are calculated from both income statement and balance sheet. For example, net margin may be quite attractive say 10% higher than the industrial average. This is good but when we calculate ‘turnover of receivables”, we may find it very small say just two times. It means that on the average it takes six months to collect the credit sales as against industrial average of 15 days.

PACKAGES LTD, LAHORE

Some key turnover ratios

Here are some of the turnover or efficiency ratios:

  • Turnover of Accounts Receivables
  • Turnover of Raw Materials
  • Turnover of Finished Goods
  • Turnover of Fixed Assets

In all ratios, sales are used as the denominator except for raw material where it is cost of raw material consumed and finished goods where it is cost of goods sold.

The ratios are compared with industrial ratio and, if none is available, against the previous years’ level. As a rule, the higher the turnover, the better it is.

PACKAGES LTD, LAHORE

Now finally the Returns.

Returns are not different from rate of profit. Both represent the same figure. Investments and assets are also the same. One fine difference may be that investments may represent financial instruments like shares and bonds, whereas assets would be mostly physical assets like land, building and machinery.

Returns can be calculated directly or through multiplication of different ratio relating to the same concept. Famous in this category is DuPont Ratio.

Main indicators of Returns are:

  • · Return on Assets
  • · Return on Equity
  • · Earnings Per Share

Return On Investment

Conclusion

Profitability is the ability of a company to generate earnings. It is measured against some base like sales, equity and assets. Since one base like sales is used for calculating various ratios, these ratios become interdependent. As such a change in sales or any other common base would affect many ratios.

Performance is measured through profitability and efficiency. The two go together but, sometime, profitability may be sacrificed for increase in efficiency. A company may reduce price drastically in order generate demand and to go into full production but such measure may be not improve the bottom-line rather reduce the profit.

Most of the ratios differ widely between industry to industry except ROI and ROE. The last two ratios reflect financial impact of operations. If ROI in one industrial sector is poor, investment would move towards other attractive sectors. Therefore, each industry has to ensure adequate ROI to attract investment.

PREVIOUS HUB - Long term debt-paying ability

NEXT HUB

More by this Author


Comments 6 comments

Rufi Shahzada profile image

Rufi Shahzada 6 years ago from Karachi

Dear Sir,

Thanks a lot. Very helpful Indeed!

Regards

RUFI SHAHZADA


stars439 profile image

stars439 6 years ago from Louisiana, The Magnolia and Pelican State.

great hub. God Bless You


LeanMan profile image

LeanMan 6 years ago from At the Gemba

Profit is the most important factor for any business, after all why is anyone in business? However far too often businesses use a short term view of their profit to drive their behavior causing problems in the longer term, such as outsourcing key skills and products overseas for a quick profit improvement.


hafeezrm profile image

hafeezrm 6 years ago from Pakistan Author

Thanks LeanMan for your comments. I fully agree with you. Nowadays, the emphasis is not on profit but on Balance Scorecard which also takes into account operational environments, innovation and customers' satisfaction. Someone has rightly said that a firm should not maximize profit but shareholders networth which, as you have rightly described, takes a long term view and not a short term one.


vishal mire 4 years ago

thank you very much for that information. this information is useful in my project


hafeezrm profile image

hafeezrm 4 years ago from Pakistan Author

Thanks Vishal Mire for your comments.

    Sign in or sign up and post using a HubPages Network account.

    0 of 8192 characters used
    Post Comment

    No HTML is allowed in comments, but URLs will be hyperlinked. Comments are not for promoting your articles or other sites.


    Click to Rate This Article
    working