The basic premise of profitability analysis is to show the ability of a company to generate profits from its day-to-day operations. As such, it is one of the cornerstones in financial statement analysis.
This of course, is of outmost importance in ensuring a return to shareholders that is satisfactory.
Profitability ratios are not only used by investors. Just like investors use it to judge the ability of a company to generate returns, creditors use it to judge whether they will get their money + interest back.
In this regard, investors will usually use profitability analysis together with efficiency ratios to evaluate a firm and creditors will use it in conjunction with liquidity analysis.
And after reading this page, you will know whether Coca Cola or PepsiCo has performed the best in the last four years.
(Hint: It’s PepsiCo)
As for the taste… we would rather not get into that.
In the following, we will present a step-by-step guide to profitability ratios. The basic steps are:
- Identify key metrics to be used
- Find these metrics in the financial statements
- Compute ratio
This is the basic steps. Ideally, the ratios should be compared to:
- Historical financials, i.e. is the trend of the ratio positive or negative?
- Other companies in the same industry, i.e. how are we doing compared to our competition. We will throughout the page benchmark Coca Cola against PepsiCo
In this guide, we will do all the above so after reading this, you are ready to jump into the world of financial statement analysis.
Gross profit ratio (gross margin ratio)
Definition of gross margin ratio:
The gross margin shows the proportion of profits generated by the sale of products and services without considering the fixed costs of a company.
In other words, it is what is left after variable costs are paid.
Gross Margin analysis
In effect, the gross margin ratio shows how profitable it is for a company to sell its products.
The gross margin only considers, the direct selling costs associated with the product. As an example, when Apple sells an iPhone, its gross margin from this is the material costs of the phone.
It is always better to have a higher gross margin than a lower gross margin.
There are two ways to increase gross margin:
- Save on material costs. This can be done by getting a lower price from the current supplier or shift supplier
- Sell the product at a higher price
Gross margin example
As mentioned in the intro, a gross margin of say “50%” doesn’t explain much. Is 50% high or low?
It all depends on the company. For some companies, a 50% gross margin will be very bad whereas for others, it will be extremely good and unrealistic.
As we covered in the intro, it is important to benchmark the gross margin against its own trend and against competitors’ gross margin (or any financial ratio). And throughout this we will use Coca Cola and Pepsi as examples to analyse.
As can be seen from the picture above, Coca Cola has had the better profitability over the period and it has been very stable at 60%-61% each year.
This means that for every dollar you spend on a bottle of Coke, Coca Cola has spent 40 cents on the drink you are consuming.
While Coca Cola are doing better than Pepsi, Pepsi has seen its gross margin increase by 1 percentage points each year.
This means, that Pepsi has closed some of the gross margin gap it had to Coca Cola in 2012.
Operating profit margin (EBIT margin)
Definition of EBIT margin:
The EBIT margin shows the profitability of all operating activities of a company.
Operating profit margin (EBIT margin) analysis
The only items that are “lower” on the income statement than Operating Profit is interest expenses (nothing to do with operations), other income or expenses (one-off items) and tax (which cannot be avoided), and thus the EBIT margin is a pure measure of the company’s ability to create profit.
To see this, assume two companies are exactly the same. However, one has debt and the other doesn’t. In this instance, the EBIT margin will be the same for both companies, whereas using a net income ratio will skew the results of the operations of both firms.
Operating profit margin (EBIT margin) example
Below the development in EBIT margin for Coca Cola and Pepsi is presented.
It is clear, that since 2012 both companies have experienced a declining EBIT margin.
However, while PepsiCo’s EBIT margin has declined from 14% to 13% over the period, Coca Cola’s has declined from 23% to 20%.
This is particularly interesting as both companies have increased their gross margin ratio. Normally, you would expect both companies to increase their EBIT margin when gross margin increases, however, this has not been the case.
This means, that both companies have been using relatively more of their revenue and items such as marketing, administration and salaries.
In isolation, this is a negative sign for the company. But this is not necessarily the case.
For example, investment in advertising might not materialize until next year (there is a lag effect) and thus, one should exercise caution before stating with certainty, that it is a negative development.
Another thing to note is that Coca Cola performs better than Pepsi on the measure. This was to be expected due to Coca Cola’s gross margin being 6% higher than Pepsi’s.
Coca Cola has an EBIT margin that is 7% higher than Pepsi’s and thus, while Coca Cola spends slightly less on items such as marketing and administration, the two spend roughly the same proportion of revenue on SG&A.
Net profit ratio (profit margin)
Definition of profit margin:
The profit margin shows the ratio of income left for the shareholders of the company after all expenses have been paid.
Profit margin analysis
The profit margin is a very interesting ratio for the shareholders of a company as it shows what is left to them after all expenses have been paid.
However, the EBIT margin is a better measure of the overall profitability of the firm.
To see this, let’s revisit our example of the firms from the EBIT margin section: A firm with large debt might be a sound business but have a very low profit margin due to the debt. If this debt was paid out it would thus appear as a solid company, although only the financing structure has changed.
Profit margin example
If we looked at the EBIT margin from above what would we expect from Coca Cola and Pepsi?
The answer is that we would expect both company’s profit margin to be lower due to the EBIT margin being lower.
So, let’s see what the result is:
As expected, the profit margin of Coca Cola has decreased from 19% to 17%, however, it is noteworthy that it jumped from 15% in 2014 to 17% in 2015.
That means, that although Coca Cola’s profit margin has declined in total over the period, the picture is not as bleak as it was in 2014 as it increased 2 percentage points in 2015.
And a profit margin of 17% is still quite high…
Pepsi on the other hand has had a steady profit margin so while there is a stable trend, the picture remains of a low profit margin compared to Coca Cola.
Return on assets (ROA)
Definition of return on assets (ROA) ratio:
Return on assets shows how efficiently a company manages its assets. The higher the ratio the better.
Return on assets analysis
The sole job of an asset is to create value (i.e. revenue) for the company. Thus, the ratio shows, how good the company is to get a return on its assets.
The ratio is especially important for asset heavy companies such as manufacturers and mining companies, whereas it is less meaningful for low asset companies such as consultancy firms.
In short, return on assets measures how profitably the asset of a company are.
Return on assets example
From previously, we already know that profit margins have been stable throughout the period. As assets normally have a steady development we would also expect the ROA ratio to be relatively stable for both firms.
This is indeed the case as it has been stable to slightly decreasing for both companies.
There are a couple of things to note here:
#1 It is the same for both companies: This is not surprising as they are in the same industry and will basically need the same infrastructure to operate.
#2 Why is it n.a. in 2012? The ratio says that we should use the average assets over the period. This is defined as (beginning assets + end of period assets) / 2. As beginning of period assets is equal to end of last period assets we thus have (assets end of last period + assets end of this period) / 2.
And as we do not know what the assets were at the end of 2011, we cannot compute the ratio for 2012.
Return on Invested Capital (ROIC)
Definition of Return on Invested Capital (ROIC) ratio (also sometimes referred to as return on capital employed or ROCE):
Return on capital analysis
Return on Invested Capital is one of the truest measures of profitability. It takes the entire company financing (debt and equity) and measures how much each invested dollar earns.
It is thus a highly relevant ratio for both debt and equity holders as it shows the ability to first pay the debt-holders. This is of course highly relevant for equity holders as everything that is left afterwards goes to the equity holders.
Return on capital example
The return on assets ratio was similar for Coca Cola and PepsiCo and we would also expect the return on invested capital ratio to be similar.
Again, this is indeed the case.
However, the trend has been highly different for the two companies.
Coca Cola has seen a decreasing return on capital going from 19% in 2012 to 14% in 2015. During the period, it has also dipped below PepsiCo which has had a stable ratio.
If I was Coca Cola I would characterize this development as worrisome and consider ways to improve the ratio.
Return on equity (ROE)
Definition of return on equity (ROE) ratio:
Return on equity shows how the rate of return equity holders receive on their invested equity.
Its function is to measure how much each dollar invested into the company earns, so a ratio of 1 means that for every dollar invested, you get one dollar in return (which is considered very high).
Return on equity analysis
The equity ratio is by many stock market analysts considered to be the most interesting measure when doing financial statement analysis as it measures the return on every dollar invested as equity.
We know from our earlier calculations that Coca Cola has higher margins than Pepsi across the board.
However, this does not necessarily imply, that Coca Cola also has a higher return on equity.
The reason is, that while the nominator is the same as in calculating profit margin, we are now shifting focus from “how much is left of revenue” to “how much bang for the buck are we getting”.
So, without further ado, let’s get on with the analysis.
Coca Cola has had a relatively stable development in return on equity when looking at the entire period. However, it is also clear that the trend was negative in the first three years before it jumped in 2015.
This is not surprising and links well to the development in the profit margin which had the same trend.
As for PepsiCo, the company has significantly increased its return on equity. This was not what we expected from analysing the profit margin.
As we know PepsiCo has kept its profit margin relatively steady, this implies that equity is now significantly lower.
This is indeed confirmed when looking at the balance sheet.
Here we can see that equity has decreased by almost 50% and it is thus the reason for the increase in return on equity.
A word of caution regarding ROE…
… the percentages are based on book value of equity. Normally, you would also calculate these based on the market value of equity for both firms.
Below we have presented the trend for both companies.
From the analysis we have done, it is quite evident that Coca Cola has experienced a negative development overall, whereas PepsiCo has experienced a slightly positive development.
Now it’s your turn
This concludes our introduction to profitability analysis.
We hope you enjoyed it and if you have any comments please post them below.
Or perhaps, you have questions about a step in the process?
We’ll be around to reply and answer questions.
So, if you have a question or a thought, leave a comment right now.