Profitability Ratio Analysis: Financial Ratio Analysis Explained

Profitability Ratio Analysis: Financial Ratio Analysis Explained

Improve the Returns on Your Business, Investments or Grades with this easy-to-follow but comprehensive lecture on profitability ratio analysis.

Within this 30-min tutorial, we cover the following profitability financial ratios:
1) The Profit Margin
2) The Gross Profit Margin (aka Gross Profit Percentage)
3) The Return on Assets (ROA)
4) The Return on Equity (ROE)

Within each Ratio Section, we review:
a) The Formula (plus an example)
b) Where to Find the Required Data Inputs
c) How to Interpret the Results
d) Drawbacks of the Ratio

All Ratios Covered are based on Profitability Analysis and assessing the Financial Performance of a Business. Each different Ratio explained in this tutorial has a unique angle on how to Analyse the Profitability of a specific business.

These ratios are based on accounting theory and make use of financial statements. Ratio Analysis (along with horizontal analysis and vertical analysis) forms part of fundamental financial statement analysis.

Using the Income Statement and Balance Sheet you can use Ratio Analysis to gain an insight into the business that is otherwise unavailable from the static Financial Statements.

Turn accounting data into Valuable & Actionable Information with Financial Ratio Analysis.

Watch this tutorial now, listen again later & share this mini-lecture anytime! You too can understand how to Use & Apply profitability Ratio Analysis in your accounting study or personal stock investment strategy.



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Closed Caption:

hi I welcome to this our brief tutorial
on profitability ratio analysis
so an introduction to performance
analysis using financial statements that
is what we recover
are we going to talk about for
particular ratios they are the profit
margin the gross profit margin the
return on assets and the return on
equity and they all involve
profitability of the business and
performance are freed ratio we're going
to go through the formula and a quick
example
we're going to talk about where we were
fine where we find the required data
inputs for the ratio
we're going to talk about how to
interpret how to interpret the specific
result as well as how to interpret
changes in the result and that's what's
most important is analyzing changes over
time and then we're going to talk about
particular drawback to reach ratio in
the conclusion I it's important to stick
to the end of the clip to the end of the
lecture because this conclusion is
important to talk about different ways
to conduct ratio analysis and then we'll
talk
talks about our key i beez the to
consider with all the ratio analysis and
then finally we do some for further
support and also ask for your feedback
ok so let's get cracking the profit
margin are the profit margin tells us
how much profit is generated from sales
it specifically the percentage of sales
revenue that end up on the bottom line
as profit and it's a great indicator of
course control and/or pricing power of
the business
he's the formula the profit margin is
simply net income divided by sales
having you and he's an example
so I'll leave that for a couple of
seconds can help with the numbers and it
works out to be our twenty three point
seven percent for the profit margin
given those figures
ok where do we find the required inputs
or net income simply comes from the
bottom one of the income statement and
sales revenue is the top line from the
income statement
all right how to interpret the results
in our example here the figure of 23.7
and this simply means that 23.7
ourselves revenue ended up as profit or
in other words a hundred minus twenty
three point seven or 1-20
three-point-seven percent means that
76.3 percent of our sales sharing i went
to expenses
all right how to interpret changes in
the results and i'll keep reminding you
that you go to analyze changes in
particular ratios to really get the best
benefit
firstly arithmetic Lee means that
expenses have changed in relation to
sales and this could mean that our
management is affected with their cost
control or ineffective if it's living
expenses have increased they could be
economies of scale to being utilized so
you could have a change in sales revenue
based on scale without a resulting
change and expenses and it also could be
a change in the bargaining position
along the supply chain
so this could mean that are you if you
have a strong bargaining position on the
supply chain you could drive Daniel your
expenses or maybe of a weak position you
may be our a price taker and a lot of
you're in a lot of your costs and
expenses could be increasing the other
side of the equation you said sales
revenue could have changed in relation
to expenses
this could be a change in pricing power
so you have a strong bargaining position
with your consumers and you can increase
prices without a corresponding increase
in expenses
this is always a really good position of
a business even if your if your
customers value your product and you can
continually charge higher and higher
prices and so will have at the same
level of sales it's a very good position
for business because there's also the
general factor a change in the state of
the economy and aggregate demand so
simply you could do very little with a
booming economy could be two sales
revenue Bruce sales and and and keep
your expenses quite low
without a result of the increase in
expenses and there's also market of
market competitive position pressures so
that means I their new entrance the to
the market or you have strong
competitors
and possibly they drive down the price
in the market you may have to follow
suit and that all decrease ourselves for
having me
alternatively I'm this has to do with
pricing varies is a link to but not not
ideally a complete linked but I'm if
you've got a strong position in the
market and there are a few competitors
you might be able to increase the sales
having you without a corresponding
increase in expenses like a drawback to
the ratio
you'll find that the the profit margin
is very industry-specific so some
industries have a have naturally higher
or natural or profit margins and other
industries
so it's all it sometimes be difficult to
to compare businesses on based on profit
margin are across industries and I
secondly are the problem
the profit margin can also be affected
by strategy and the ratio doesn't take
account for that
so I'm an example that I've used before
is that would you rather a business that
had a forty percent profit margin on a
hundred dollars revenue or a business
that had a ten percent profit margin on
a billion dollars in sales revenue so
I'm doesn't take care of the scale and
often a strategy can least locally to an
increase in scale and have you would
always see the benefits in the profit
margin at the next one the next ratio
will look at is a is a gross profit
margin and this is our very important to
our ratio for resellers and
manufacturers
so I so particular businesses that hold
inventory and specifically it's a profit
between the cost of inventory and the
sales price or in other words how much
sales revenue is left to cover profit
and all other expenses
in other words it's um it's a difference
between the sales revenue and cost and
the cost of your inventory expressed as
a percentage to use the formula
I you take you have sounds revving -
question with soul and then you try to
completely by Silas wrapping you
and if there's an example there with a
few figures you want to punch me and see
if you can work it out but what it what
remains that had actually first of all
was getting his first taken to take a
specific
where do we find the required input the
South River you simply from the income
statement and the cost of goods sold is
from the income statement as well cost
of goods sold is also known as question
revenue or cost of sales
it simply I the American you pay for
your inventory costs so I'm
hypothetically if I if you're running a
business that sells widgets and I spend
seven dollars to purchase a widget that
you're going to let a resale
so you you pay your supplies seventy
dollars for that region and your cost of
goods sold would be seventy dollars when
you solve that widget and ideally you'd
sell it for put yourselves revving you
would be a higher than cost of goods
sold
so I'm let's let's let's go back a bit
so you're crossing a good soul would be
1846 that's what you pay for your
widgets
I want you sell your widgets for is 5777
and I you
if we calculate that formula then that
will be a gross profit margin and 68 . I
for let's go back forward again get a
key
let's go already how do we interpret the
results
so our was going to start the bottom
first are the 68 . 04 result
it simply means that that's the sales
revenue this is remaining to meet our
expenses and required profit our other
expenses or in other words a hundred
percent - 60 . 04 simply means that 31.9
six percent of ourselves where we went
to purchase or create our inventory so i
went to purchase our widgets or create
our widgets
all right how to interpret changing the
result one side of the equation is that
sales revenue has changed in relation to
our cost of goods sold our cost of you
Tori this could be again
that's a cow i mention this now as i was
doing this why i noticed that there
there's a lot of repetition in some of
these raisins and some of these
interpretations
this comes down to the fact that all of
these ratios our profitability ratios
and because they're all focusing on one
aspect of the business profitability
you'll find that quite a few of the
reasons kind of revolve around the side
the same IDs and you find that are each
individual ratio so it's a particular
purpose or has a particular angle but
they're all revolve around profitability
so that there are some similar
there are some some more reasons behind
them so I'm the first move out here is a
change in the pricing pal
so you're bargaining position with
consumers again
you people value your your product or
value the businesses product and you're
able to charge a higher price then our
self driving you can increase without a
cost of inventory
I'm an example is that like Apple Apple
may pay the same for very tablet that
I'm the samsung model or she army might
but people who purchase have products
for like myself are we really value them
and we're willing to have a premium
price so Apple has a apples pricing
power and good bargaining position
without with the apple fanboys and
fangirls also there once again it's a
changing product or aggregate demand
without a flow through the supply chain
yet so Eve arm a particular business has
has a spike in demand for their
particular product then they may get our
an increase in sales revenue through on
through are boosting sales or Bruce and
sales price normally over time it is a
boost to aggregate demand and the supply
work flow right through the supply chain
so Eva
it was at the end of the business
Bruce's prices
you might find that the this applies end
up raising their prices as well but
until the supplies Bruce their prices
then a spark in aggregate demand without
a corresponding increase in those prices
from the supplies i will way to a
improved gross profit margin
I want to get their market competitive
positions and pressures so I if your
sales revenue is changed and they could
be changing the competitive market may
be increasing competitors or decreasing
back competitors and so forth and also
once again a change in business strategy
so you beat this could be discounting
their products and that could be a
particular strategy perhaps for a black
friday be a war or are just a general
they want to change their position in
the market and there is no fall in their
cost of good solved our cost of goods
sold is abbreviated coges capital c 0 GS
so they could be discounting without a
corresponding fall and cost of goods
sold or cost of goods sold
alternatively has changed in relation to
sales driving you
this could have to do with power and
supply chain the example that i always
use these are walmart our walmart has
our power in the supply chain and it can
drive down its cost of goods sold its
cost of inventory because its power
the flip side is I you have no power in
the supply chain and your supplies might
be able to increase their prices and and
you have no choice
and your question with so good it could
increase other other simple reasons you
may just change supplies business major
set change supplies and question was
also changed or they could be production
efficiency if you produce your products
yourself and you may have our you may
have found them at different waiter to
to produce your products and your coat
and your classic with Souls change
because of our different production
process
all right the final one mentioned he is
a changing prices of particular
commodity the inputs
if you're in an industry where they are
part of the cost of goods sold our
global commodities then you may have
absolutely no influence over the
quantity price
it might be take it or leave it sort of
proposition and in particular changes in
commodity prices might directly impact
impact of cost of goods sold
you have to think about it from my
company like um company like starbucks
and they purchase coffee beans are over
and over again all throughout the year
so if there's a change in arabica beans
are robbing bings are the prices of
those or the changing coffee beans
globally then their closet with Saul
will change as commodity inputs change
the drawback to the ratio
once again it's very industry-specific
so I you'll find some industries have
high gross profit margins are walk some
have very alone
secondly I'd it's a narrow ratio to test
the overall performance and can ignore
many expenses profitability ratios is a
lot about performance and the injury the
first so I talk bad performance measures
through financial statements when you're
only when you're only focusing on the
inventory cost you are ignoring many
expenses throughout the business so you
may have a great
gross profit margin baby can control
your other course then you may know it
may not result in there you know in a
high profit at all the comedy total from
the gross profit margin
the third ratio or can get is a return
on assets and this is the return from
the assets for those who funded the
assets or the return generated by the
assets for those who funded the assets
I now you mention that that every single
and not imagine but if you can go on
with the with the fact that every single
acid in the business is funded by the
equity or debt then the return on assets
I explains the return
all right let's just go to the next
slide to the formula
all right you can see the inputs
involved income before tax
so that's the return for the equity
holders and the other input is interest
expense and that's the return for arm
for debt holders or dent dead funders
so it is the return generated by the
assets for those who funded the assets
it either being equity holders or debt
holders
it's also an inside into the success of
management in the income generating
asset allocation in utilization
decisions
so if management is doing a good job by
in purchasing assets and using those
assets to generate a return then it
should show up in the return on assets
when it when it focuses on equity
holders and debt holders you always will
in both of those groups want to know how
successful management is at its asset
allocation in utilization
alrighty use the formula i I'd income
before tax in inches expense and that's
the numerator and then you divide that
by the assets of the start of the period
play CSS to the end of the period / - so
simply to the average assets over the
over the period and need to write and
that's too far and that is that the
denominator is dividing income before
tax plus interest expense
there's a few digits we can punching if
you have the same result and the return
on asset
16.1 a percent in that in that in that
example
all right where we find the required
inputs income before taxes simply from
the income statement inch this expense
is also from the income statement access
to the start of the period is from the
previous balance sheet
so that's the balance sheet that was
that was created for last . and assets
of the end of the period is from the
current balance sheet so that's from the
balance sheet from today
so you if you if you want had an average
in one from the start of the period and
one from the end of the period and since
the balance sheet is um is a photo
rather than a video you want the balance
sheet for today for the end of the
period and won the previous balance
sheet for the start of the period
and how do we interpret the result 16.1
eight percent in our example was
returned from the assets that's what the
assets generator forest or you could say
that 16.1 eight cents was generated for
every dollar invested in the assets and
is available for as a return for those
who find the assets that is being the
equity holders and those being the death
holds all right how do we interpret
changes in the result one side of the
equation is probabilities changed in
relation to the level of assets in
effect eve if profitability is
increasing in relation to the to the
level of acids
this means management is getting more
from left in regards to the assets
it is getting more bang for his back
from the available assets
I'm in other words management has made
good asset allocation decisions in terms
of revenue and it's generating more
revenue for a specific level of acids or
it could mean the management is good
cost control in relation to expenses so
it's owning arm same revenue same level
assets but expenses a date racing and
that will increase profitability in
relation to the level of assets and once
again this is properly built in to
measure
once as i mentioned earlier some of the
reasons carry over to this thing's hot
the general state of the economy the
market power with customers and also
supplies and also the competitive
position in terms of marketing in them
and the competitive market
I think also the other side of the
equation is the level of assets have
changed in relation proper ability
one example is that our assets may
suddenly increasingly there was the last
capital if there was a recent large
capital expenditure so assets may have
suddenly doubled and the resulting
profitability hasn't changed the the new
assets haven't become profitable yet and
I and there could be um a change the
level of assets from capital expenditure
without a corresponding increase in
profitability as yet
that's the assets are increasing arm of
assets the decreasing this may mean that
assets and being replaced or replenished
at the same rate
so assets are form quite quickly or not
quite a group of assets are falling with
with attitude without a change in
profitability and I'm this may be as a
result of a particular choice in
depreciation depreciation and
amortization
so I depreciation and amortisation
policies or a choice of management or a
choice of the finance department
the and assets are the value of assets
specifically rights to the cost of the
asset for the value of the asset - are
the given depreciation and amortization
so the the depreciation policy does have
an impact on this result
you know the drawbacks of the ratio we
can hide or disguise a lack of him asset
investment as mentioned out for the acid
level of acids can increase the return
on that is because you have a smaller
denominator in the ratio but it's never
a good idea to let the asset pace where
I'm too low
we always want some level of assets in
the business so i can hide or disguise a
lack of effort as an investment
for instance you wouldn't want your
actions to drop down to ten dollars or
one door
I can in theory i'm a hundred dollars a
profit on one dollar assets is it is a
very high return on assets but I it's so
not necessarily good idea that your
assets drop to zero and i'm having no
income generating on capability anymore
and as I mentioned earlier we are the
choice of depreciation policy on how can
have a big effect and this means that
the this distance this could imply that
the return on assets can be toys you
manipulated by carrying policy
it can affect both are the profitability
aspect of it management management
choose a particular accounting policy
that least a higher profit but
specifically arm
the choice of depreciation and
amortization policy for the asset can
have a big I can have a big impact on
the return on assets and that is a
drawback in the final Rachel going to
look at is the return on equity
this is a little similar to on the
return on assets by instead of walking
in the return generated for the equity
holders and the dead holes this
specifically looks at the return a
generative the owners of the business
and these the equity holders or the
common stockholders is also I a it also
shows in insight into the success of any
leverage use when comparing to the
return on assets
what you'll find is that if the return
on equity is higher than the return on
assets
this is an indicator that the business
is successfully using our borrowings it
successfully leveraging their
investments and now that that's um
depending on your on your viewpoint on
debt that is a good sign
but I guess it's always a good sign of
the successfully leveraging dead
everything the business rather than one
successfully level of breaking the
pieces
all right is the formula it's our net
income with the bottom line
- preference evidence we take out
preference dividends because they are
not generally there are they are the
common stockholders and remove the
owners of the business there
they it's kind of like a hybrid between
dead and equity so we take our
preference dividend and then that's the
numerator net income minus preference to
my dividends and we simply divide that
by the average common stockholders
equity over the period which is a common
stock all of the equity the start of the
period plus the equity the end of the
period / -
and once again this is an example if you
want to pause it and I'm punching a few
numbers and see if you have the same
result
and that's great and in the example we
had 13.5 percent as the return on equity
so where do we find the required inputs
and everything comes from the income
statement preference dividend is also
from the income same it's not always
from the income statement some some mom
financial websites put in the income
statement but you can always finding the
company investor relations section
company announcements common
stockholders equity the side of the
period is from the previous balance
sheet and common stockholders equity at
the end of the period from the current
balance sheet and that's are similar to
the assets inputs from the previous
ratio
all right how do we interpret the
results simply me our example is 13.5
percent and it means that our 13.5
percent of the equity with job return
for the owners over the period or the
13.5 since was generated for every
dollar of common stock holder funds in
the business how to interpret changes
are one side of it is our profitability
has changed in relation to the level of
common stockholders equity and this
means that the management performance is
changing the eyes old and on behalf of
the owners of the employers
or their employees the owners being the
employees and management his own is
directly owners are like the board and
the board our employees management
so I'm since you use net income in the
figure it incorporates all the almost
all of it it incorporate all the
decisions of management
so it is a big indicator it's a strong
indicator that the performance
management and generating a and
generating an income and it has this is
in relation to on common stockholders
equity which means it's on behalf of the
common stockholders or the owners are
going to repeal the previous ones but
there are the factors that in there are
involved
the economy market power competitive
position plus cost control and added
state usually and we've added cost
control and asset utilization the other
than the other factor is the common
stockholders equity is changed the
relation of profitability
this could be because the level of
liability to changed and that's equity
because if you know your accounting
equation arm equity equals assets minus
liabilities
so why ability to change without a with
that am corresponding um changin assets
than common stockholders equity will
form and the ad the other factors equity
may be increased that be through
reduction in liabilities or even could
be through a stock issue or perhaps is
decreased aqua stock buyback
so there could be changes in liabilities
are quickly changes in equity to
actually threw a stock issue or stock
buyback
all right roll back to the ratio the
ratio can be easily manipulated by the
level of liabilities
so I'm normally normally not normal
let's start again and it can be easily
manipulated by the level of why but that
is how I run through the example that a
of all expenses that come into the
business of being placed on on credit
and they're all been put on
on a banker before after or credit card
or or alone then it'll increase the
level of liabilities also decreasing the
level of equity saving with the same
profit the decreased the increased level
of liabilities will decrease the level
of equity and that will improve the
return on equity because the equity
figure be getting smaller profitability
remain the same and the only change is
an increasing the level of liabilities
which is always a good sign
and there's also a heavily relies on
landing net income finger and while I
don't have the skills or the time to
fully explain my proper manipulation and
profit massaging
there always are some choices by
management and some choices by the
finance team that can influence the
netting company car over a particular
period because of that because of
accounting policy
all right let's go . the conclusion the
different ways to conduct ratio analysis
there's trend analysis and this is when
you look at a single ratio over
different periods
this is very important you look at how
how ratios change over time
that's how I that's why I included that
particular section of the of age ratios
i'm out in our analysis of a change the
ratio so it's important that you look at
the time the trend of ratios are you can
also do it
I can compare particular ratios against
their competitors or against other
benchmarks
so that's using a single ratio against
different companies or other than the
company itself or finally you multiple
ratios at once
this is something I use I look it out
perhaps three or four different ratios
and painting pay a bit of a picture
i'm using those are different results I
across Oh across a variety of ratios and
again you can do that again use multiple
issues you can do training also do some
comparisons to bench months
kids with all ratio analysis is I'm the
calculation is the easy part
it is termed ratio analysis . ratio
calculation
so while it's important to know the
formulas I'm you shouldn't arm to simply
rely on the result
you should use the results as a basis
for inquiry
so there the ratios as symptoms of a
particular arm
of particular concern as you use a ratio
is hold some not as the knowledge of the
diagnosis or the prognosis but you
should take them on as symptoms and then
from there in take further investigation
to find out what the particular
diagnosis
secondly our ratio analysis is not a
one-off task we can door once and then
just put a report in the bottom drawer
never get it again
I ratio analysis requires an ongoing
system
so every quarter or a 36 month serbia
and more every year
I you should I repeat the process and
see how things have changed and again
used to trend analysis over time
you should have an ongoing set set
system a regular routine and I finally
you need not use every ratio under the
Sun every time I come over time as you
do these are more and more you'll have a
particular favor ratios you can you can
do your own tests and see how you go
but you don't have to do you know how to
use perhaps all four of these prop
profitability ratios every single time
you look you can hopefully from the
explanation will see some of the
differences between them and I'm through
your own practice
ifsc which ones are best suited to your
investing style or your particular
business and from there you can pick and
choose which one suits you best
you wouldn't heed not necessarily have
to use every single ratio that on your
profitability but leverage ratios and
efficiency ratios and so forth
you're going to have a hundred and one
ratio is I'm every single corner
already I congratulations are we're done
if you need any help or clarification
anything you just saying or come across
i'm getting in touch i'm more than happy
to help my love this online online
teaching stuff and I'm more than happy
to help you get in touch and I secondly
our feedback is always welcome
um i would like to be able to offer
lessons that that that you're looking
for
rather than telling you what you should
learn so I'm really know what you want
to even if you get in touch and tell me
what you like or what you don't like or
what you need or you need help with them
or what you'd like to learn about so on
feedback exactly always welcome
thanks very much for your time and I'm
have a lovely day