Profitability ratios

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From the course by Indian School of Business

Accounting and Finance for IT professionals

77 ratings

Indian School of Business

Accounting and Finance for IT professionals

77 ratings

Course 3 of 6 in the Specialization Business Technology Management

This course presents an introduction to the basics of financial accounting and finance for IT professionals. The first part of the course will focus on understanding the most important financial statements, namely, the balance sheet, the income statement, and the statement of cash flows. We will then focus on how we can understand the financial health and performance of the company by examining a number of important financial ratios that are derived from the financial statements of the company. The second part of the course will focus on the basics of finance. This includes the concept of time value of money, discounting cash flows, and capital budgeting. The course will also introduce the idea of real options, how they affect a project’s NPV, and their impact of the decision to accept/reject a project. Lectures on concepts will be supplemented with numerical examples.

From the lesson

Financial Statement Analysis

The purpose of this module is to equip you with the skills required to identify accounting information required for building trading strategies. After completing this module you will be able to calculate the key financial ratios.

Financial Statement Analysis3:38

Profitability ratios6:00

Activity Ratios8:35

Solvency and Liquidity Ratios6:53

DuPont Identity4:56

Meet the Instructors

Ramabhadran Thirumalai
Assistant Professor
Indian School of Business

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In this video, we will look at some of the common profitability ratios,

like return on equity, return on asset, gross profit margin,

operating profit margin, net profit margin, etc.

We will continue to use Amazon's financial statements to

compute these financial ratios.

The first couple of profitability ratios measure how well the company has used its

balance sheet resources to generate profit.

These two ratios are Return of Equity, ROE, and Return on Assets, ROA.

ROE is defined as the net income divided by the average shareholders' equity.

The denominator is the average over two consecutive years.

For 2015, we will average shareholder's equity from the 2014 and

2015 balance sheets.

The reason we average over two consecutive years

is that this number will change at least a few times in a year.

So we won't know the exact level of shareholders' equity on

each day during the year as profits are generated.

In most cases, when we have one balance sheet item and

one income statement item as a part of a ratio,

we will use this method of averaging for the balance sheet item.

To calculate Amazon's ROE for 2015,

we know that its net income for 2015 is $0.60 billion.

Its average shareholders' equity for 2015 is $12.06 billion.

Dividing $0.60 billion by $12.06 billion,

we get an ROE of 0.494 or 4.94%.

For every dollar of shareholders' equity,

Amazon earned a little less than $0.05 in profits.

Similar calculations yield ROEs of negative 2.35%,

3.05% and negative 0.49%, respectively, for 2014, 13 and 12.

This shows that Amazon's profitability has not

been very stable over the last few years.

And that it has been at its most profitable in 2015.

The next profitability ratio is ROA.

It is defined as a company's net income divided by its average total assets.

Average total assets are defined much like average shareholders' equity for ROE.

In 2015, Amazon's net income was $0.60 billion and

its average total assets were $59.97 billion.

Dividing the net income by the average total assets, Amazon's ROA for

2015 works out to be 0.99%.

Every $1 in assets owned by Amazon in 2015 generated profits of less than $0.01.

But similar to ROE, 2015 was the most profitable year for

Amazon over the last four years.

But its profitability changes quite dramatically every year.

Now other types of profitability ratios are all based only on income

statement items.

This gives us an idea as to how well the company is managing its costs and

hence maintaining its profitability.

The first of these ratios is a gross profit margin, or gross margin.

The gross margin is the ratio of the company's gross profit for

the year divided by its revenues for the year.

Gross profit is the difference between revenues and cost of goods sold, COGS.

The gross margin tells us how well the company has managed its manufacturing

costs or direct costs incurred in the delivery of its services.

Companies would like the gross margin to be higher.

In 2015, Amazon had revenues worth $107.01 billion and

COGS worth $71.65 billion.

Its gross profit was $35.36 billion, which when divided by its revenues and

expressed as a percentage, use a gross margin of 33.04%.

Comparing Amazon's gross margin over the last four years,

you can see that is has consistently increased every year since 2012.

You can add its variables and COGS, both have increased over the last four years.

But revenues have increased at a faster rate than COGS,

leading to an increase in gross margins over time.

The next profitability ratio is the operating profit margin

which is defined as the operating profit divided by revenue.

Operating profit is also known as EBIT, earnings before interest and taxes.

Amazon's EBIT in 2015 was $2.23 billion and its revenue was $107.01 billion.

This gives us an operating profit margin of 2.09%, which is, again,

the highest in the last four years.

The fifth profitability ratio is the pretax margin,

which is the earnings before taxes divided by revenues.

Amazon's earnings before taxes in 2015 were $1.57 billion.

Dividing this by its revenues of $107.01 billion gives

the pretax margin to be 1.47%.

Yet again, this is the highest in the last four years.

The final profitability ratio we look at is the net profit margin or net margin.

It is the net income divided by revenues.

Amazon's net income in 2015 was $0.6 billion.

Dividing this by revenues of $107.01 billion gives

Amazon's net profit margin to be 0.56%, again, the highest in the last four years.

Based on all the profitability ratios, it appears that Amazon is doing well

in the most recent year compared to its recent past.

Though its gross margin is 33.04%, its net margin is only 0.56%.

Amazon's COGS is two-thirds of its revenues,

whereas its other expenses account for almost all of the remaining one-third.

To get a better sense of whether these ratios are too high or

too low, Amazon's ratios should be compared to those of its competitors.

In the next video, we will look at some of the more popular activity ratios.

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