Updated: May 14
Welcome to our new series "Ratio Analysis 101", where we discuss the beautiful inner workings of the core of financial analysis, ratios! Ever tried the crazy task of comparing a private company with $10m sales turnover with a multi-national listed firm with $10b in revenue using purely absolute figures? How crazy would that be?
Ratio analysis enables such analysis by scaling numbers into percentages, making it more digestible. As percentages themselves are meaningless when viewed in isolation, ratios should be compared against 1) historical performance, 2) expected performance from the financial model or proforma statements, 3) peers (a friendlier way to term competitors) and, 4) the industry average to yield meaning insights. With that in mind, let us embark on this exciting journey into profitability! Do feel free to leave a like or comment!
TABLE OF CONTENT
Why Conduct Ratio Analysis?
Profitability Ratios in a Nutshell
Gross Profit Margin
Net Profit Margin
Earnings Per Share
Non-GAAP Profitability Ratios
How to Conduct Profitability Ratio Analysis?
WHY CONDUCT RATIO ANALYSIS?
Financial analysis is done to evaluate a business entity's financial performance. Financial analysis is typically conducted by external users such as investors and financial institutions to better understand the business's historic performances, so the assumptions used to power a financial model can have a reasonable basis. Internal uses such as managers and accounts also conduct ratio analysis for corporate financial planning and internal control purposes.
Ratio analysis is an integral part of the financial analysis framework and is used to evaluate businesses, projects, and other finance-related transactions. For external users, ratios are used to make informed investment decisions, such as deciding if monies should be invested or lent to the organization. Regulators also conduct financial analyses in a bid to maintain the integrity of the capital market by uncovering fraudulent and potentially-insolvent companies.
As we know, the goal of corporate finance is to enhance shareholders' value. The illustration below illustrates the role ratio analysis plays in 2 valuation scenarios
For internal users such as managers and accountants, financial ratios act as performance targets that are tied with the corporate financial planning and budgeting process. For example, the firm plans to achieve a 20% net profit margin. To achieve that, the CEO assigns profitability targets for each division. Managers also conduct ratio analysis on competitors to better comprehend their strengths and weaknesses while accountants and auditors do it to identify irregularities, which may suggest that fraud is going on.
PROFITABILITY RATIOS IN A NUTSHELL
Profitability ratios are performance metrics that measure the ability of the organization to generate profits as a percentage of revenue. Analysis of profitability ratios is important as it is indicative of how well the business can generate returns at each stage of the financial statement. It allows users to identify which function is the company strong at and what are its weaknesses.
Profitability ratios largely rely on the inputs available in the income statement. Also known as the P&L statement, it summarizes the revenues and expenses incurred during a reporting period. It is one for the 5 essential statements that must be presented under IFRS, which also include the balance sheet, cash flow statement, statement of change in equity and the footnotes.
Genevieve is a shareholder of a boutique pizzeria, K-Pizza. She receives a copy of the financial statement a week before the annual general meeting. The illustration below is the income statement excerpt.
GROSS PROFIT MARGIN
Gross profit can be calculated by deducting the cost of goods sold (COGS) from revenue. COGS is the direct cost of producing the goods that are sold by the organization, which includes the direct material used, direct labour involved and production overheads. Therefore, gross margin measures how well an organization is optimizing its procurement and production-related activities.
Genevieve calculates the gross margin and arrives at 72% (350/500). She then conducts further analysis to identify the factors that are driving the gross margin by diving into the footnotes disclosure and obtaining the breakdown for COGS.
She then compares the COGS breakdowns of current and past periods and discovers that the sales increase has been accompanied by steadily increasing gross margin with the proportion remaining consistent. With the average selling price (ASP) experiencing little change, she then concludes that the company is likely benefitting from the economic-of-scale from the higher number of pizzas sold.
It is imperative for an organization to have gross profits as a negative margin entails that the company is losing more money for additional units produced. It calls for an immediate price increase and reduction in costs. Otherwise, it is wiser to cease operations immediately. Last but not least, the gross margin could be affected by the inventory valuation method. If the company uses FIFO in an inflationary environment, it results in a lower COGS and higher gross margin. Contrarily, using AVCO will result in higher COGS and lower gross margin.
OPERATING (EBIT) MARGIN
EBIT is calculated by deducting recurring OPEX from the gross profit. It is a measure of how effective the company is earning revenue and how efficient operating costs are managed. In short, it is a barometer for measuring how well the business is generating income from everyday operating activities.
EBIT margin provides an overview of the true cost of operating the business, by considering revenue, COGS, and OPEX. Genevieve proceeds to derive the EBIT margin of 36% (180/500) for K-Pizza. She then continues to identify the sources of the difference and obtains the breakdown of OPEX to identify the company's cost structure.
To make the comparison more meaningful, she calculates the EBIT margin and breakdown of a publicly-listed peer, Corleone Pizza, which has a slightly higher EBIT margin of 40%. By breaking the revenue, COGS and OPEX into its components, Genevieve gains more insight into the business's operations, its sales units, average selling price, production, selling and distribution (S&D), administrative (G&A) and R&D expenses. For example, she can calculate S&D/Revenue, R&D/Revenue, G&A/Revenue ratios to compare the effectiveness and efficiency of the firm's marketing and sales, research and development, and administrative endeavours
As the EBIT margin gauges the ability of a business to generate profit from everyday business activities, managers may misstate revenue and expenses to artificially inflate or deflate the EBIT margin to meet unrealistic profit expectations, avoid breaching the loan covenant, etc. Therefore, it is also a good practice to compare ratios to make sure that it is not out-of-line when putting side-by-side against past performances and industry peers. The principles of extraordinary circumstances require extraordinary evidence applies here!
The pretax margin captures the effect of non-operating incomes and expenses, as well as the impact of the company's capital structure on profitability. The interest expense, which is the required return that a borrower has to compensate the lender, will be higher when the business is largely financed by debt and/or is less creditworthy.
It might be potentially misleading to compare the net (post-tax) profits of companies when they are based in different tax jurisdictions. Genevieve decides to compute and compare the pretax margins of K and Corleone Pizza, as K-Pizza is a local company while Corleone is an international franchise. She proceeds to calculate a pretax margin of 30% (150/500) for K-Pizza and runs through the footnotes to investigate the difference for the EBIT and pretax margins.
But one drawback is the inclusion of non-operating incomes and expenses which may skew performance when they are significant. One common adjustment that financial statement users undertake is to remove them when conducting profitability analysis.
The net profit measures the residual amount after all expenses are deducted from sales. The ratio expresses net profit(loss) as a percentage of revenue. It is one of the most closely watched yardsticks for investors because it suggests how well the business is generating profits and returns for shareholders.
Some managers also appreciate the importance of net income to investors. Factors such as shareholders' expectations, public scrutiny, bond covenant, shares prices, and management compensation might compel them to manipulate earnings using the following methods.
Aggressive recognition which pushes current sales up at the expense of the future.
Underestimating doubtful debt, sales return, warranty, etc.
Record nonoperational income as operating revenue.
Reduce D&A by increasing the asset's lifespan and salvage value estimate.
Delay expense recognition which pushes up current profit at the expense of the future,
Record OPEX as an asset and depreciate instead of expensing it in the reporting period.
Not writing down doubtful receivables, impaired assets, obsolete inventory, etc.
Delay sales recognition, creating a reserve to smooth future performances.
Accelerate expense recognition, again to smooth future performances.
EARNINGS PER SHARE
Earnings per share (EPS) make more sense for investors like Genevieve as it scales earnings to a per-share basis. There are 2 kinds of EPS. The basic EPS measures the net earnings allocated to each share while the diluted EPS considers the exercise of dilutive securities and shares options. So what are dilutive securities?
CONVERTIBLE BONDS & PREFERRED SHARES
Convertible bonds and preferred shares allow the holders to convert debt and preferred share instruments into common shareholding at a specific price and time. Such instruments are typically granted at 2 specific business life stages, during the initial growth stage when there is potential for growth but success is not a certainty and the decline stage when the fund is needed to finance a restructuring.
As the risk is higher during these periods, lenders might be apprehensive when it comes to lending. To entice creditors to supply much-needed capital, businesses may have to compensate them higher interest for the higher risk assumed or offer them the option to convert the loan into a predetermined number of shares at an attractive price at specific points-of-time, so lenders can benefit from the company's growth.
If the business performs well and its share prices increase, it allows lenders to purchase shares at a lower-than-market price and immediately sell it at the market price to make a profit.
Share options are awarded to employees, affording them the option of purchasing a predetermined number of shares at a specified price at certain points of time, to keep them vested on the company's growth. The dilutive effect can be observed using the treasury shares method. For example, Genevieve is considering investing in Corleone Pizza and would like to analyze the dilutive effect of shares option. Upon examining the footnotes, she finds out that a total of shares options granted is 500, and they allow holders to purchase at $2.00 per share. The share price of the Pizza franchise at the time of analysis is $2.50.
Proceeds if all shares options are exercised: $1,000 or (500 shares x $2.00 exercise price)
Shares that can be bought: 400 shares or ($1,000 proceeds ÷ $2.50 market price)
Net dilution: 100 shares or (500 - 400 shares) to be added to the denominator.
Under IFRS, it is required to present EPS after net income. The business is also required to separately report the financial performances of discontinued operations, which are parts of the business that have been abandoned, sold, or disposed of. By separating the financial performance of discontinued operations from recurring activities, it helps increase the transparency and accuracy of future profit forecasts for external users of financial statements.
NON-GAAP PROFITABILITY RATIOS
A non-GAAP (Generally Accepted Accounting Principles) cannot be computed in a straightforward manner as their inputs are not found in the P&L statement. But with a bit of simple calculation, it gives users additional insights into the organization's finances.
EBITDA Margin Ratio
EBITDA, or earnings before interest, tax, depreciation and amortization, is computed by adding depreciation and amortization (D&A) expenses back to EBIT. It is a quick and dirty method to estimate the business's cash flow from operations or in another word, its ability to generate cash from its everyday activities by excluding non-cash incomes and expenses, such as D&A expenses and unrealized paper gains and losses.
One of the ways that managers can increase profit is aggressive recognition of revenue such as booking revenue before products are shipped or by selling to customers on loose credit, negatively impacting collectability. By scaling EBITDA to revenue, one can get a rough estimation of the percentage of revenue is made up of cash. The ratio also measures the cash-generating ability of the corporation. As debt repayments are made in cash, the level and stability of this ratio are of special concern to creditors and financial institutions.
Contribution Margin Ratio
Contribution Margin (CM) is a measure used by internal users to measure the company's earnings after deducting all variables costs. As businesses are not required by GAAP to separate fixed and variable costs in the financial report, such sensitive business data is, unfortunately, can only be accessed by corporate insiders.
Although COGS is generally characterized as a variable cost, as in it increases with the number of products sold, it also has a production overhead component which includes fixed costs. The selling and distribution costs in OPEX also varies with the sales level. By deducting sales-dependent variable costs, it allows managers to assess if the contribution margin is sufficient to cover fixed overheads and conduct scenario analysis to measure the impact on profitability stemming from changes in the number of units sold.
HOW TO CONDUCT PROFITABILITY RATIO ANALYSIS?
We cannot understate the fact that financial ratios are meaningless when viewed in isolation! So users should use them to measure relative performance against 1) historical performance, 2) expected performance, 3) peers, and 4) the industry average. Doing that will enable the user to better understand the strengths and weakness of the company. By combining that with market insight, one can infer how well the business is capitalizing on opportunities and defending against threats.
There is also a prevalent risk that earnings are managed, lowering the quality of analysis and causing investment decisions to be made on shaky premises. As financial analysis is usually the precursor to financial modelling, one good practice that external users adopt is to normalize the earnings by remove non-recurring incomes and expenses. Doing that helps remove the short-term distortions brought upon by significant one-time incomes and expenses, such as gain and loss from an asset sale. Financial analysis using the normalized earnings is then conducted, allowing users to compare the impact of non-recurring items. Normalized earnings help enhance predictability when doing financial modelling.