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Profitability Ratios: How Profitable is the Company?

Net sales/Net profit after taxes

The information necessary to determine a company’s profit as a percentage of sales can be found in the company’s income statement.

1. Magnetronics’ profit as a percentage of sales for 1999 was $1,307 divided by $48,769, or 2.68%.

2. This represented a decrease from 3.6% in 1995.

3. The deterioration in profitability resulted from a decrease in cost of goods sold as a percentage of sales, and from a decrease in operating expenses as a percentage of sales. The only favorable factor was the decrease in the income tax paid.

Management and investors are often more interested in the return earned on the funds invested than in the level of profits as a percentage of sales. Companies operating in businesses requiring very little investment in assets often have low profit margins but earn very attractive returns on invested funds. Conversely, there are numerous examples of companies in very capital-intensive businesses that earn miserably low returns on invested funds, despite seemingly attractive profit margins.

Therefore, it is useful to examine the return earned on the funds provided by the shareholders and by the “investors” in the company’s interest-bearing debt. To increase the comparability across companies, it is useful to use EBIAT (earnings before interest but after taxes) as the measure of return. The use of EBIAT as the measure of return also allows the analyst to compare the return on invested capital (calculated before the deduction of interest expense), with the company’s estimated cost of capital to determine the long-term adequacy of the company’s profitability.

4. Magnetronics had a total of $15,249 of capital at year-end 1999 and earned before interest but after taxes (EBIAT) $1,824 during 1999. Its return on invested capital is calculated as follows:

Earnings before interest but after taxes (EBIAT)/Owners' equity plus interest - bearing debt

In 1999 this figures was %, which represented a decrease from the 14.67% earned in 1995.

From the viewpoint of the shareholders, an equally important figure is the company’s return on equity. Return on equity is calculated by dividing profit after tax by the owners’ equity.

Profit after taxes/ Owners' equity Return on equity

Return on equity indicates how profitably the company is utilizing shareholders’ funds.

5. Magnetronics had $12,193 of owners’ equity and earned $1,307 after taxes in 1999. Its return on equity was 10.72%, a deterioration from the 15.22% earned in 1995.

Management can “improve” (or “hurt”) its return on equity in several ways. Each method of “improvement” differs substantially in nature. The analyst must get behind the return on equity figures and must understand the underlying causes of any changes. For example, did Return on Sales improve? Did the company’s management of assets change? Did the company increase the use of borrowed funds relative to owners’ equity? These three possible explanations are combined in the Du Pont system of ratio analysis:

ROE Net Income/Sales x Sales/Assets x Assets/Equity

Activity Ratios: How Well Does a Company Employ Its Assets?

The second basic type of financial ratio is the activity ratio. Activity ratios indicate how well a company employs its assets. Ineffective utilization of assets results in the need for more finance, unnecessary interest costs, and a correspondingly lower return on capital employed. Furthermore, low activity ratios or a deterioration in the activity ratios may indicate uncollectible accounts receivables or obsolete inventory or equipment

Total asset turnover measures the company’s effectiveness in utilizing its total assets and is calculated by dividing total assets into sales:

Net sales/Total assets

1. Total asset turnover for Magnentronics in 1999 can be calculated by dividing $48,769 into $22,780. The turnover deteriorated from...
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