Profitability

Profitability Ratios, also known as Performance Ratios, help investors evaluate the ability of a business to generate profit considering its sales, assets, and shareholder's equity.

Gross Profit

There are three major types of profits -

gross profit
operating profit
net profit

Each of them are significant in their own way.

Gross Profit is the amount of money a company earns after deducting the costs directly associated with producing their goods/products/services from the revenue. These costs are collectively known as Cost of Goods Sold or COGS.

How do we define COGS though and what do directly associated costs mean? Interestingly, the answer can vary depending upon the company we're looking at. Let's look at some examples.

For a capital intensive company like Motherson Sumi which deals with a lot of tangible raw materials, it should be expected that the cost of materials consumed would be relatively high. Purchase of stock-in-trade measures the expenses incurred in buying products used as intermediates to create the finished products sold by the company. Change in inventories of finished goods, work-in-progress, and stock-in-trade, as the name implies, are the expenses incurred on creating the products left in the inventory of Motherson Sumi at the end of the financial year 2020.

These costs can be considered directly associated with creating the end product. Expenses like the finance costs or depreciation & amortization aren't directly related to the creation of the end product. We can ask the following question to think whether an expense qualifies as COGS — would this expense have emerged even if no sales were generated? If yes, then it probably shouldn't be included in COGS.

The labor costs incurred to produce the end product are also direct costs eligible for inclusion in COGS. However, this should only include actual labor costs paid to employees responsible for creating the product, not employees in marketing or HR, for example. This is a conundrum because the notes for employee benefit expenses looks like this

We don't know the details of how much of the salary, wages, & bonus are direct costs. The details are not mentioned possibly due to competitive and logistical reasons.

We leave the decision of inclusion of employee benefit expenses in COGS up to the reader and his/her judgement which will possibly be influenced by the company in question and its nature of business. Please note that these expenses would still be reported under the operating expenses and end up getting reflected in the operating profit.

In this case, we'll consider COGS as

COGS = Cost of Materials Consumed + Purchase of Stock-in-Trade + Changes in Inventories of Finished Goods, Work-in-Progress, and Stock-in-Trade

Now that we know how to calculate COGS, we can calculate the gross profit.

Gross Profit = Revenue from Operations - COGS

The Gross Profit Margin of Motherson Sumi and TCS for the year 2020 are as follows

Gross Profit Margin = Gross Profit / Revenue from Operations

Earnings Before Interest, Taxes, (Depreciation and Amortization) (EBIT/EBITDA)

EBIT, as the name implies, is the amount of profit a company earns before interest and tax expenses have been subtracted. It is also known as the Operating Profit. We can also strip out depreciation costs of tangible assets and amortization costs of intangible assets from the expenses to obtain the EBITDA.

You can use the following formula to calculate EBIT.

EBIT = Revenue from Operations - ( Total Expenses Excluding Taxes - Finance Costs )

To calculate the EBITDA, we can simply exclude the depreciation and amortization expenses. The formula then becomes

EBITDA = EBIT + Depreciation and Amortization Expense

Why is the EBIT and EBITDA of a company relevant?

EBIT and EBITDA present us with an ideal view of the companies' core operational performance by excluding non-operational expenses like interests and taxes. While the net profit might be skewed by variables like taxes, EBIT and EBITDA will present the true picture of how much the company actually earned from its operations.

Like most financial ratios and metrics, EBIT and EBITDA are best used for comparison of companies in the same sector. Comparing the EBIT margin of a MNC pharmaceutical company with that of a capital intensive auto ancillary company doesn't make sense.

EBITDA can, however, be misleading and it may not be useful, especially in asset heavy companies with significant depreciation and amortization costs. Here's what Warren Buffet has to say about EBITDA.

People who use EBITDA are either trying to con you or they’re conning themselves. Telecoms, for example, spend every dime that’s coming in. Interest and taxes are real costs.

Here's what Charlie Munger has to say about EBITDA.

I think that, every time you saw the word EBITDA, you should substitute the word "bullshit" earnings.

Profit Before Tax (PBT) and Profit After Tax (PAT)

You should be able to find PBT in the profit and loss statement in an annual report.

Profit After Tax (PAT), also known as the Net Profit, is arguably one of the most important metrics in an annual report. It is what we usually mean when we ask "how much profit did the company earn?". PAT is the metric which tells how profitable a company is after all its expenses are considered and deducted from the revenue.

Like PBT, you should be able to find PAT in the profit and loss statement in an annual report.

The PAT margin, also called net profit margin, is a widely used metric to calculate and compare the ability of companies to generate profit.

Unlike operating profit, note that we're using total income, which includes other income as well, to calculate the net profit and net profit margin.

Return on Equity (ROE) and Return on Assets (ROA)

Return on Equity is a widely used profitability ratio that measures how many rupees of profit are generated for each rupee of shareholders equity. It highlights how efficiently a company uses the shareholders equity to generate profits. It can be calculated using the following formula:

Return on Equity = Profit after Taxes / Shareholders Equity

Depending on the source, we might find a slightly different formula for ROE.

Return on Equity = Profit after Taxes / Average Shareholders Equity

You can calculate average shareholders equity by calculating the average of the shareholders equity at the beginning and at the end of a financial year.

One might ask — why consider the average of shareholders equity and not the total shareholders equity for a specific financial year?

Of course, if the difference between shareholders equity in successive financial years isn't driven by one-off events like buybacks or additional issue of share capital, considering the average shareholders equity may not be needed.

Similarly, Return on Assets can be defined as the amount of profit generated by a company relative to its total assets. We can use this metric to judge how well a company utilizes their assets to generate profits. It can be calculated by using the following formula:

Return on Assets = Profit after Taxes / Total Assets

Just like ROE, we can use average total assets instead of just total assets when needed to calculate ROA.

Besides the definition that we shared above, ROE and ROA can be expressed using the DuPont Identity, also known as the DuPont Method, which breaks down ROE and ROA into several ratios and presents us with a detailed and an alternative view.

According to the DuPont method, ROE can be written as

Return on Equity = Profitability Ratio x Efficiency Ratio x Leverage Ratio

Profitability Ratio is the PAT margin we've seen before. The Efficiency Ratio is Total Income / Average Assets and the Leverage Ratio is Average Assets / Average Shareholders Equity. If you observe closely, the DuPont Identity gives back the original definition we shared if we cancel out the relevant numerators and denominators from the above formula. However, by breaking up ROE into 3 different ratios, we can now know how the ROE figures of Bombay Dyeing ended up getting inflated.

Let's start with the year 2019. We can break down Bombay Dyeing's ROE as follows:

Although the profitability ratio and efficiency ratio (also known as asset turnover ratio) are decent, what ends up inflating ROE is the leverage ratio (also known as equity multiplier) which indicates that Bombay Dyeing's assets are mostly funded through debt rather than equity which is a point of concern.

The DuPont formula for ROE ends up revealing ROA as well when we multiply the Profitability Ratio with the Efficiency Ratio. This means that ROA is a function of a firm's profitability and its asset turnover capability.

Besides the highlighted limitations in this section, the usual caveats apply. ROA and ROE are best compared against firms in the same sector with similar business models.

Return on Capital Employed (ROCE)

Return on Capital Employed (ROCE) is a measure of how much money can a company generate in the form of profits considering the amount of money invested in it for the long term.

After reading that definition, one might think, how do we calculate the "amount of money invested in a company for the long term"?

If we use the accounting equation in this case, we can say that

We can define ROCE using the following formula

ROCE = EBIT / Capital Employed

where

Capital Employed = Shareholders Equity + Non Current Liabilities

One might find Capital Employed defined as Total Assets - Current Liabilities which is just another way of using the accounting equation. The former method of looking at capital is called the financing approach and the latter method is called the operating approach. We can also use Average Capital Employed to prevent looking at skewed ratios because of abrupt changes in Shareholders Equity or Non Current Liabilities.

The ROCE of Bombay Dyeing for the year 2019 is

It should be apparent that ROCE is a "better" profitability ratio to use compared to ROE, especially in capital intensive sectors like telecom and auto where assets being funded by significant debt isn't unusual.

Return on Invested Capital (ROIC)

One of the drawbacks of ROCE, as we saw earlier, was that it considers cash reserves as part of the capital employed which ends up subduing the ROCE of Abbott India. Instead of looking at capital employed, how about we consider the capital invested in a business? After all, the ability to generate cash isn't the only thing that matters. A company sitting on huge amounts of cash isn't necessarily a good thing since the returns generated from that cash is not going to exceed the cost of capital employed and the expected returns by shareholders. We'd want a company to make use of that cash effectively and grow its business better than its competitors. Efficient capital allocation matters just as much, if not more, than how capital is employed and it is one of the most important responsibilities of the management of a company. Its importance is perhaps best highlighted by the following excerpt from Warren Buffet's 1987 letter to shareholders.

The heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics. Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered.
In the end, plenty of unintelligent capital allocation takes place in corporate America. (That's why you hear so much about "restructuring.") Berkshire, however, has been fortunate. At the companies that are our major non-controlled holdings, capital has generally been well-deployed and, in some cases, brilliantly so.

The Return on Invested Capital (ROIC), also known simply as Return on Capital (ROC), is the measure of profit generated by a company relative to the amount of capital invested in its business.

Okay, so how do we define what capital invested is?

We defined capital employed as Shareholders Equity + Non-current Liabilities but it can also be written as Total Assets - Current Liabilities using the operational approach. We can exclude

cash and cash equivalents, bank balances, term deposits, and interest
income from cash
goodwill
unusual and one-time items

Excess cash sitting in a bank or in debt funds isn't invested in a business and isn't an operational asset. Goodwill is an intangible asset usually resulting from the acquisition of a company at a premium value. We exclude goodwill because it is the leftover premium from the past, not an investment for future growth. Similarly, other one-time items like asset write downs aren't included in the capital invested since they are not core operational assets.

This gives us

Non-operational Assets = Cash and Cash Equivalents - Goodwill - Misc One Time Items
Capital Invested = Total Assets - Current Liabilities - Non-operational Assets

This gives the denominator in the formula for ROIC. Since we are focusing on the invested capital from an operational standpoint, we'll use operational profit in the numerator. However, instead of using just EBIT, we'll adjust EBIT for taxes to get a more standardized version of operating income. This is known as net operating profit after taxes (NOPAT).

ROIC can now be defined as

NOPAT = EBIT x (1 - tax rate)
Capital Invested = Total Assets - Current Liabilities - Non-operational Assets
ROIC = NOPAT / Capital Invested

There's another caveat we should keep in mind when calculating ROIC. The NOPAT generated at the end of a financial year won't be because of capital invested at the end of the same financial year. To account for this timing difference, the amount of capital invested used in calculating ROIC will be as it was at the end of the preceding financial year.

The capital invested of Abbott India for the year 2019 is

Of course, like any other ratio, ROIC has its limitations.

ROIC, and its constituents, are non-standard metrics that we may not find anywhere in an annual report. We have to calculate NOPAT and Capital Invested ourselves, manually, to avoid mistakes and incorrect calculations. Although we considered the timing difference when calculating capital invested, some stock screening websites may not do so and use capital invested at the end of the year in question which is incorrect.

ROIC can also mislead investors into preferring asset light companies with relatively higher ROIC than asset heavy companies with relatively lower ROIC.

PreviousFinancial Metrics and Ratios NextUsing Screeners

Last updated 3 years ago