The goal of every company is to make profit. Of course, you know that If a company is not making money the business will collapse.
As profits/earnings grow, the company grows. As an investor, your Return on Investment grows too.
Cash is king. Without cash, debt can’t be paid off and company’s end up filing for bankruptcy. So to counter any bad investments you will always want to know how profitable a company is.
The company needs cash to run the business operations. If profits are not being made, the money invested on its operations is a waste. To avoid this set back you need metrics to know if the capital or cash invested in the business is converting to profits.
These ratios below will tell you how profitable a company is.
⦁ Return On Tangible Asset (ROTA)
ROTA = Net income/ Average total tangible assets
A company acquires assets such as factories and equipment which are used to conduct their business operations.
Return on tangible assets tells you how good a company is putting its tangible assets to use.
The higher the return on tangible asset the better. Return on tangible asset tell you how much a company is generating for every $1 of tangible assets it owns.
Note: In my analysis, I exclude intangible assets because it is difficult to place a price tag on brand names, trademarks and intellectual properties. Companies take advantage of intangible asset to inflate their total assets.
Assume a company reports $50000 net income and owns $5000 in tangible asset. Its Return on tangible asset is $10 or 1000%. That is, for every $1 of tangible asset the company owns, it generates $10 in profits each year.
⦁ Return On Equity(ROE)
ROE = Net income/ Average stockholder equity
Another word for equity is ownership. ROE tells you what is the profit from owning a company’s shares. How well a company rewards its shareholders for investing in the company.
A higher ROE is good. It tells you how much is generated from holding $1 in equity. Be careful of excessive debts. Excessive debts inflates ROE. Be sure the trend of a company’s debt is reducing consistently.
Assume a company reports $50000 of net income and its shareholders have $100000 in equity. Its ROE is $0.5 or 50%. That means, for every $1 of equity share holders own, the company generates $0.5
⦁ Profit margin
Profit margin = Net income/ Sales
Profit margin tell you how much of sales a company is making. A higher profit margin is good. The more sales, the better. A higher sales means a company is generating revenue. The profit margin tells you how much an investor makes for every $1 in sales.
Assume a company reports $100000 in sales with a net income of $300000. Its profit margin is $3 or 300%. That is, the company generates $3 for every $1 in sales.
Note: These ratios on its own cannot tell you much. But if you compare these ratios to previous quarters or years or its industry average. It can tell you if the company is a leader or a laggard and you want to be focusing only on companies that are improving on its returns every year and quarter.