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How to determine the profitabilty of a company

The profitability of a company tells you if the company is making profits or is losing money. There are a few key numbers you can check. These are (among others):

  • Net profit margin
  • Return on assets
  • Return on equity

Although these numbers will give you some clues they will never tell you the entire picture. If a company is not making profit, that does not mean the company is not financially healthy. Maybe they are investing and borrowing a lot of money. On the other hand, if a company is not making profits for 10 years in a row that might be a signal to have a good look in the financials and why they are not making any profits.

34.1 Net profit margin

Measures how much profit a company generates for each dollar of revenue (shown as a percentage or decimal).

In other words, how much money is leftover after each $1 in sales when every expense (wages, production cost, transport, etc.) is paid.

34.1.2 How to use net profit margin

A net profit margin of 25% means that $0,25 for each $1 in revenue is generated as profit.

You typically want a high profit margin. This means that for each $1 in sales the company makes more profit. This shows the investor how the business is run in general and compared to other companies in the same industry.

  • Higher profit margin is better (more profit)
  • Above 10% is considered healthy
  • Can be very different between industries
  • Can be used to compare companies

The three steps every investor should look at:

  • What is the current net profit margin?
  • What is the long term trend?
  • How does it compare to the industry?

34.1.3 Why do investors use net profit margin in their analysis

Helps to determine the company's efficiency. If profit margins remain low (below 10%) and there are no improvements to make in production costs or other areas that might be a warning sign. If profit margins are high that means the company has low overhead costs.

34.1.4 Things to be aware of

  • Only compare with other companies in the same industry
  • Net profit margin should rise over the years
  • Can be influenced when a company sells assets (profit will increase while costs remain the same)
  • It won’t show what part of the company is doing great or needs improvement (it only looks at total revenue and total net income)

34.1.5 How to calculate net profit margin

  • Net profit margin = net income / revenue * 100%

34.1.6 Higher is better

The higher the net profit margin, the more efficient the company is generating income. This helps investors to determine how the company is managing money. The net profit margin is an important indicator when diving into the financial health of a company. Overall, you want to see the net profit margin rising over the years. That means the company improved their production and made it more efficient (if possible).

You can use the net profit margin to compare companies within the same industry. If there are two companies where one is much bigger but the smaller one has a higher net profit margin, that means the smaller company is more efficient with their operational costs and other things. 

Important: Profit margins can be very different between industries. Companies with assembly lines or transports are much more prone to see shifting in prices for fuel, ingredients and maintenance compared to companies that only provide services. You should never compare net profit margin between different industries. 

34.2 Return on assets

Shows how profitable a company is in relation to its total assets. In other words, how effectively the company is using their resources to generate profit.

For a farm, a tractor is considered an asset. The tractor helps ploughing the land making it possible to plant and harvest crops. But the tractor might be old and needing maintenance all the time reducing efficiency. Return on assets indicates how effectively the farm is using the tractor (and other assets that help the core business) to plough the land.

34.2.1 How to use return on assets

 5% return on assets means the company generated $0,05 for each $1 in assets.

  • Higher is better
  • Above 5% is considered healthy
  • Can be very different between industries
  • Can be used to compare companies

An investor should always look at:

  • The current return on assets
  • The long term trend
  • How it compares to the industry (the competition)

34.2.2 Why do investors use return on assets in their analysis

Shows the investor how effectively the company is using its resources to generate profits.

34.2.3 Things to be aware of

  • Only compare with other companies in the same industry
  • If a company has many assets changing over time, it’s better to calculate the average assets instead of the total assets.

34.2.4 How to calculate return on assets

  • Return on assets = net income / total assets * 100%

ROA is an important ratio as it will tell you how effectively the company is using its resources to generate profits. Example:

Bob and Kristin both sell ice cream in the summer. They both have an ice cream truck. The truck Bob owes cost him $20.000 and the truck Kristin owes cost her $1500. Over the summer, Bob earned $2000 and Kristin earned $200. To calculate the return on assets:

  • Bob: $2000 / $20.000 * 100% = 10%
  • Kristin: $200 / $1500 * 100% = 13.3%

This tells you Bob’s company is more valuable but Kristin's company is more efficient. Be aware that total assets can change over time. A transportation business will buy and sell trucks or planes all the time. Before using return on assets as a guideline, you have to know what the exact assets are. For a company that has many assets changing over time, it’s better to calculate the average assets instead of the total assets.

34.3 Return on equity

Measures the profit in relation to shareholders equity.

A publicly traded company (any company that issues shares to the public) is owned by its shareholders. The entire company’s holdings is called shareholders equity (total assets - total liabilities). Return on equity calculates the amount of profit for every $1 the shareholders invested.

34.3.1 How to use return on equity

10% return on equity means the company generated $0,1 for each $1 the owners (shareholders) invested.

  • Higher is better
  • Above 15%-20% is considered healthy (always use industry average)
  • Can be very different between industries
  • Can be used to compare companies

34.3.2 Why do investors use return on equity in their analysis

To find out the owner's attidue toward their company. 

34.3.3 Things to be aware of

  • Only compare with other companies in the same industry
  • Does not include intangible assets (non physical assets like licences, computer software, etc.)
  • Equity, stockholders equity and shareholders equity refer to the same thing
  • Liabilities should not be more than three times return on equity

The three steps every investor should look at:

  • What is the current return on equity?
  • What is the long term trend?
  • How does it compare to the industry?

34.3.4 How to calculate return on equity

  • Return on equity = net profit / shareholders equity * 100%

A negative shareholder equity is a warning sign. It means the company has more liabilities than assets. It might also mean that the owners did not invest enough money or they are taking money out of the business. Don’t stare too much at lower numbers. $0,06 does not seem much but this totally depends on the industry and other factors. You should always compare these numbers with other companies in the same industry.

I already calculated the return on equity for each company and compared them with the industry average. Use the search bar on top, fill in your favorite company and find out how they perform.

Key Concepts:

  • The profitability of a company tells you if the company is making profits or is losing money.
  • The net profit margin measures how much income or profits a company generates as a percentage or decimal of the revenue. This is based on every $1 in sales. Meaning, if the profit margin is higher, the company is keeping more % of every dollar as profit.
  • Return on assets indicates how profitable a company is in relation to its total assets. In other words, how effectively the company is using their assets to generate profits.
  • Return on equity measures the profitability of a company in relation to it’s equity. Equity is ownership of assets that may have debts or other liabilities attached to them.

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