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.

Net profit margin

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 high, the company is keeping more % of every dollar as profit.

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. But before you can determine the net profit margin, you first need to calculate the net profit:

• Net profit = revenue - expenses
• Net profit margin = net profit / net revenue * 100

For example, if the net profit margin is 25%, that means the company is keeping $0.25 for each $1 in sales as profit. This way you can 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 way more efficient with their operational costs and other things.

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. 

If you are using my trading tool, the net profit margin is already calculated for every company. I also compared the net profit margin within the industry of the company. So you can check if the margin is below or above average. An example:

Return on assets

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. Where assets are basically everything that can be sold for cash. For example, a company that is in the transportation business has many assets in the form of trucks or planes. 

The return on assets ratio is displayed as a percentage and is based on the net income and total assets. The calculation is rather simple:

• Return on assets = net profit / total assets * 100

It’s an important ratio as it will tell you how effectively the company is using its resources to generate profits. Like with every ratio, you can only compare return on assets between companies within the same industry. The higher the return on assets the better.

Example:

Bob and Kristin both sell ice cream in the summer. They both have an ice cream truck. The truck Bob ows cost him $20.000 and the truck Kristin uses only costs $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 Kristins company is more efficient. But in practice the 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. 

Return on equity

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. To calculate return on equity:

• Return on equity = net profit / shareholders equity

Shareholders equity is the claim shareholders have on a company's assets after debts are paid. You can find the shareholders' equity in the income statement of the company.

But return on equity does not measure intangible assets (non physical assets like licences, computer software, etc.) and future predictions for the market. Assets can also be hidden from the balance sheet. You should only compare return on equity between companies within the same industry. And you should also look at how return on equity is performing overtime and where the changes in fluctuation are coming from.

Although higher is better for each profitability type, be aware that you can only compare ratios from companies within the same industry.

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.

Chapters: The Ultimate Investing Guide