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PROFITABILITY RATIOS

Profitability ratios focus on the firm`s earnings. Net Profit Margin. If you want to know the proportion of revenue that finds its way into profits, you look at the profit margin. This is commonly defined as Net profit margin = net income = 1,990 = .089, or 8.9% sales 22,348

When companies are partly financed by debt, the profits are divided between the debtholders and the shareholders. We would not want to say that such a firm is less profitable simply because it employs debt finance and pays out part of its profits as interest. Therefore, when calculating the profit margin, it seems appropriate to add back the debt interest to net income. This would give

Net profit margin = net income + interest = 1,990 + 321 = .103, or 10.3% sales 22,348

This is the definition we will use.

Holding everything constant, a firm would naturally prefer a high profit margin. But all else cannot be held constant. A high-price and high- margin strategy typically will result in lower sales. So while Bloomingdales might have a higher margin than J. C. Penney, it will not necessarily enjoy higher profits. A low-margin but high-volume strategy can be quite successful. We return to this issue later.

Return on Assets (ROA). Managers often measure the performance of a firm by the ratio of net income to total assets. However, because net income measures profits net of interest expense, this practice makes the apparent profitability of the firm a function of its capital structure. It is better to use net income plus interest because we are measuring the return on all the firm`s assets, not just the equity investment:8

Return on assets = net income + interest = 1,990 + 321 = .108, or 10.8% average total assets (22,660 + 20,101)/2

The assets in a company`s books are valued on the basis of their original cost (less any depreciation). A high return on assets does not always mean that you could buy the same assets today and get a high return. Nor does a low return imply that the assets could be employed better elsewhere. But it does suggest that you should ask some searching questions.

In a competitive industry firms can expect to earn only their cost of capital. Therefore, a high return on assets is sometimes cited as an indication that the firm is taking advantage of a monopoly position to charge excessive prices. For example, when a public utility commission tries to determine whether a utility is charging a fair price, much of the argument will center on a comparison between the cost of capital and the return

that the utility is earning (its ROA).

Return on Equity (ROE). Another measure of profitability focuses on the return on the shareholders` equity:

Return on equity = net income average equity = 1,990 = .298, or 29.8% (6,401 + 6,936)/2

Payout Ratio. The payout ratio measures the proportion of earnings that is paid out as dividends.

Thus: Payout ratio = dividends = 757 = .38 earnings 1,990

Managers don`t like to cut dividends because of a shortfall in earnings. Therefore, if a company`s earnings are particularly variable, management is likely to play it safe by setting a low average payout ratio.

When earnings fall unexpectedly, the payout ratio is likely to rise temporarily. Likewise, if earnings are expected to rise next year, management may feel that it can pay somewhat more generous dividends than it would otherwise have done. Earnings not paid out as dividends are retained, or plowed back into the business. The proportion of earnings reinvested in the firm is called the plowback ratio:

Plowback ratio = 1 Ј payout ratio = earnings Ј dividends earnings

If you multiply this figure by the return on equity, you can see how rapidly shareholders` equity is growing as a result of plowing back part of its earnings each year. Thus for Pepsi, earnings plowed back into the firm increased the book value of equity by 19.3 percent:

Growth in equity from plowback = earnings Ј dividends equity = earnings Ј dividends earnings earnings equity = plowback ratio ROE

= .62 .31 = .193, or 19.3%

If Pepsi can continue to earn 31 percent on its book equity and plow back 62 percent of earnings, both earnings and equity will grow at 19.3 percent a year.9 Is this a reasonable prospect? We saw that such high growth rates are unlikely to persist. While Pepsi may continue to grow rapidly for some years to come, such rapid growth will inevitably slow.

8 This definition of ROA is also misleading if it is used to compare firms with different capital structures. The reason is that firms that pay more interest pay less in taxes. Thus this ratio reflects differences in financial leverage as well as in operating performance. If you want a measure of operating performance alone, we suggest adjusting for leverage by subtracting that part of total income generated by interest tax shields (interest

payments marginal tax rate). This gives the income the firm would earn if it were all-equity financed. Thus, using a tax rate of 35 percent for Pepsi, Adjusted return on assets = net income + interest Ј interest tax shields average total assets = 1,990 + 321 Ј (.35 321) (22,660 + 20,101)/2 = .103, or 10.3%