Profitability Analysis

In the previous episode of learning, we learnt some basic methods of financial analysis, primarily common size analysis. We also talked about some other methods such as ratio analysis and cash flow analysis. In this episode, we will dive deep into ratio analysis and some commonly used ratios.

When we feel that the data on the statement are not intuitive enough to tell us the performance of the company, we then want to do some calculations to get more information. Let's start from what the company cares the most. 

When we examine the business of a company, what we care the most is usually the profitability of the company. The reason is that the purpose of running business is to gain profits. If we want to know such information, which statement should we look at?

Apparently, it is the income statement. From this statement, we can see how much the gross profit and net profit are. 

Take our fictional company as an example. From its income statement, we can tell easily how much the gross profit is by using 43 million (revenue) minus 31 million (cost of goods), which is 12 million dollars. We also get the net profit directly from the income statement - 5.2 million dollars. 

Is net profit enough to judge profitability?

After seeing these figures, can we make a judgment of the profitability of the company? 

Not so fast. 

Without knowing more information on the industry or the nature of the business, it's premature to say whether this 5.2 million of net profit is big or small. In other words, we lack some crucial context. Let me tell you why.

If the profit of Walmart is 5 million this year, you will easily say that this number is horribly small. But if it is the profit of a small cafe, you will also easily say that this number is unbelievably big. So even for the same number of 5 million dollars, we will judge very differently based on the objects we are judging.

What does it mean? 

It means the figure of profit itself is not sufficient enough to understand the profitability of a company. 

And here comes the ratios, i.e. percentages.

Is net profit ratio enough to judge profitability?

We humans are notoriously bad at judging extremely large numbers. After a certain level, these numbers don't make much sense to us anymore. But we can almost always make sense of percentages and pass on judgments on top of that.

For instance, if we switch to gross profit ratio or net profit ratio by either dividing gross profit by revenue, or by dividing net profit by revenue, we can compare either ratio of Walmart and that of the small cafe. 

If you recall from the common size analysis of our fictional company, we sort of have already got the two ratios, without consciously doing so. After deducting cost of goods sold from the revenue, we got our gross profit of the company, which is 12 million dollars. Once we divide the gross profit - 12 million - by the revenue - 43 million, the gross profit ratio of 28%. 

With the same method, we can get our net profit ratio by dividing 5.2 million by 43 million, making the final net profit ratio at 12%. As we have this 12%, we can compare companies of different sizes using the same ratios.

Let's look at the net profit ratio. When we have a net profit ratio of 12%, it means that for every 100 dollars of products sold, I can pocket 12 dollars worth of profit. But if I only tell you this ratio without giving you other information, You may still find such information insufficient.

The core unanswered question will be "how many did I sell?"

Scale MATTERS!

If I only sell 100 dollars of products in total, the 12 dollars profit is ... just unsatisfying.

But if I sell 10 billion dollars of products in total, the 1.2 billion dollars profit will be exhilarating. 

Although the net profit ratio is the same for both companies, they are completely different businesses. Therefore, although we can compare Walmart and the cafe via net profit ratio, it is not hard to understand that they have different economic impacts on us. Scale matters!

Then how can I get scale?

Well, the simple answer is increasing your revenue. Even though this is very, very hard to accomplish, but let's just simplify the scenario: all else equal, the more money you invest, the higher the chances you get in increasing your revenue. This should be given.

Therefore, how much revenue a company generates should be put together with how much investment it puts into the company. 

If I write down both the net profit ratio and the ratio above, you may find something interesting: 

After we multiply the two ratios, the two revenue figures are crossed out, and we have a new ratio which is net profit over total asset.

What does it mean? 

The total asset is the amount of asset invested in this company. Net profit is the return we have. In other words, it means how much money I earn after investing such amount of resources. This is a fairly common concept that people encounter every day, called returned on investment. For our financial statements, we call it return on asset (ROA).

We once compared the income statement to a funnel, where revenue enters from the top and profit comes out from the bottom. The net profit ratio tells us how steep this funnel is: the steeper the funnel, the fewer the expense, and more revenue will become profit. Net profit ratio is a concept that measure the effectiveness of the company.

What is revenue divided by total asset then? 

If you recall, the business operations of a company is sort of like a cycle, where cash turns into inventory and/or other assets, which turn back into cash again. The company repeats the cycle again and again each year, hopefully increasing its cash position every time. All else equal, i.e. the amount of money the company makes in each cycle, the more cycles the company goes through each year, the more money it makes as a whole.

Revenue divided by total asset is called total asset turnover - a concept that measures the efficiency of the company. 

Now we can see the return of investment of a company is determined by two factors. The first factor - net profit ratio - measures how large the return is, and the second factor - total asset turnover - measures how fast the company turns cash over. 

This is also the first time that we distill management knowledge from our financial statements. By looking at the above two factors - net profit ratio and total asset turnover - you should get a better feeling at what to focus on while managing a business.