How to know the profitability of a company? How is it calculated?
Investments 101
9.15.2024 7:06 PM
Is it possible to make extra money with a small investment? It's one of the million-dollar questions, but what if we told you it's possible? The key lies in analyzing profitability indicators with a solid database, being diligent, and having the right tools.
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It's not about investing a large amount of money but about making smart decisions and seizing opportunities—like reading this post.
If you're ready to improve your financial health, let's start with the basics: What is profitability? What does it mean for a company to be profitable? How is this performance measured?
First, to define profitability, let's refer to Investopedia, which states that it is a measure of efficiency. To know how well a company is doing, these data allow both the entrepreneur and us, the investors, to decide if it's worth continuing to bear those costs against the benefits of that project.
So, when we ask ourselves how profitable a company is, we are questioning how well a company uses its assets to produce profits and value for both its shareholders and itself. We call that profit profitability as a result of an investment. But how do we measure it? That's what we'll cover in the next section.
It's simple. It's measured with ratios, also known as profitability indicators. What do we mean by profitability ratios? Basically, they are metrics that you can (and should) use to evaluate whether the money you're investing in a company is working and to what extent it will yield results.
For us, these indicators make life easier because they allow us to have a reliable data source so that we can analyze, measure, and evaluate a company's ability to generate profits from our actions and investments.
And it's no coincidence that information is power because, with all these data, you can estimate the value of a company in its entirety. If it’s a publicly traded company, the stock price should also reflect this estimated value.
The way you use them depends on who is using them: an investor or a financial analyst will use them differently than a lending institution or a business owner. The latter is motivated by profit, unlike a lender who is interested in evaluating the company’s liquidity—understood as the ability to repay a debt within a certain period.
For those of us who like to make money work and generate a return on our investment, we need to base our decisions on their results by understanding these two aspects:
Again, we encounter another term from the financial dictionary: “return rate,” which is the value that indicates the level of return on a company’s initial capital.
Now that you know why you should consider them when evaluating a company, let’s explain which are the most famous indicators and how to apply them.
To get a more accurate picture, it's necessary to analyze these indicators within:
Evaluating the indicators within these three aspects will help you find trends to make forecasts about the company's profitability, assessing its past to make intelligent financial decisions in the present.
Now, the question is to know the types of profitability ratios and how to interpret them. We’re going to present the most well-known ones. The answer can vary, but of course, the more variety you base it on, the clearer the picture will be. We’ll introduce you to the most popular ones, grouped into two categories:
Margin ratios: Also known as return on revenue indicators, they measure a company's ability to turn its sales into profits.
Some of these include the gross profit margin, operating margin, net profit margin, cash flow margin, EBIT, EBITDA, EBITDAR, NOPAT, operating expense ratio, and overhead ratio.
Return ratios: These represent a company's ability to generate returns for its shareholders or investors.
Some examples include return on assets, return on equity (ROE), cash assets, return on debt, retained earnings, revenue, invested capital, return on employed capital—these are just a few of these indicators.
But we don’t want to complicate things, so we’re going to simplify them into the four most commonly used indicators and how to calculate them.
This is a metric that compares gross profit to sales revenue—and this ratio should be analyzed as a percentage. So, if you see a high gross profit margin ratio, it indicates greater efficiency in core operations. That is, it can still cover operating expenses, fixed costs, dividends, and even depreciation, while providing net profits to the business.
Tip: Look for companies that score well on this metric, as it ensures that the company can at least cover its operating expenses, interest on debts, and more.
Gross Margin = Gross Profit / Sales
Also known as the operating profit margin, it calculates the percentage of revenue that covers operating expenses and generates a profit.
Companies with high levels of operating profit margins are generally better equipped to cover fixed costs and related interest. Furthermore, if they score high on this metric, it means they can survive an economic downturn and even offer lower costs relative to their competition.
In simple terms: it assesses the solidity of a company’s management.
Operating Margin = Operating Income / Sales
It is better known by its acronym in English—EBITDA—which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. But you might wonder, why? Because the result it gives us doesn’t reflect the total profits.
Why is it useful? Displayed this way, it makes it easier to compare it with similar companies because it excludes expenses that might be volatile or somewhat discretionary.
EBITDA Margin = Earnings Before Interest and Taxes / Revenue or Sales
If you want an indicator that reflects total profits, this is it. Also known as the bottom line because it expresses the net profit from all income minus all expenses.
It considers all the series of expenses, from interest to taxes, showing the net profit. It’s advantageous, but it does have some drawbacks as it includes a lot of data, making it more challenging to compare its performance with its competitors.
Net Profit Margin = Net Income / Revenue
Undoubtedly, it’s an important metric, but don’t be fooled. Although this metric shows a final picture, it doesn’t mean it's a final decision; you shouldn’t analyze it in isolation. It's about having a holistic view when doing financial analysis. This is what we will share with you next: some recommendations for analyzing this quartet of performance indicators.
Let's put them into practice!
Now you know what they are used for, which are the most popular, and how to calculate them. It’s time to apply them to the company you have in mind. Remember that all databases need to be organized, and the best way is through a table—in Excel or Google Sheets.
With this ready, it’s necessary to consider some points when analyzing the financial landscape.
The quartet of profitability indicators we presented is the most popular for conducting a basic financial profitability analysis. However, if you have the time and/or different requirements, don’t hesitate to feed your database with other indicators.
It’s no news that information is constantly being updated, so always determine the period in which you will analyze them. Additionally, we recommend tracking them over a relatively long term to spot trends.
Remember: the result of each indicator should not be analyzed in isolation.
We know that doing this tracking might be a bit laborious, but today there are various tools to record and measure these indicators by filling the database with information from the company you want to know. Moreover, that’s the only way to ensure your money grows as it should.
So get motivated to do a profitability analysis because everyone benefits, whether you're an investor, a business owner, or a lender! With that in mind, don’t miss our next weekly post: How to Invest in the Stock Market with Little Money, where we reveal secrets like when to use a cash flow statement, balance sheet, or cost accounting.
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