HomeОбразованиеRelated VideosMore From: AccoFina

Profitability Ratio Analysis: Financial Ratio Analysis Explained

258 ratings | 53584 views
Profitability Ratio Analysis: Financial Ratio Analysis Explained Support AccoFina's Patreon if you are a Fan or Believer in my work, https://patreon.com/accofina Time Markers: 1) The Profit Margin 1:17 2) The Gross Profit Margin 5:47 3) The Return on Assets 14:28 4) The Return on Equity 21:47 5) Different ways to conduct ratio analysis 27:56 6) Key ideas with all ratio analysis 29:06 1) THE PROFIT MARGIN Tells us how much profit is generated from sales. Percentage of sales revenue that ends up as profit Good indicator of cost control and/or pricing power. Profit Margin Formula: Profit Margin = Net Income / Sales Revenue Example Where do we find the Required Inputs? Net Income: From the Income Statement Sales Revenue: From the Income Statement How to Interpret Changes in the Ratio: Expenses have changed in relation to sales... * Management is effective with cost control * Economies of scale are being utilised. Sales Revenue has changed in relation to expenses... * Change in pricing power (bargaining position with consumers) * Change in state of the economy and aggregate demand 2) THE GROSS PROFIT MARGIN (Very important for resellers and manufacturers) Profit between cost of inventory and sales price. How much sales revenue left to cover profit and all other expenses. Gross Profit Margin Formula: Gross Profit Margin = (Sales Revenue - Cost of Goods Sold) / Sales Revenue Where do we find the Required Inputs? Sales Revenue: From the Income Statement Cost of Goods Sold: From the Income Statement How to Interpret Changes in the Ratio: Sales Revenue has changed in relation to cost of goods sold... * Change in pricing power (bargaining position with consumers) * Change in product or aggregate demand (without a flow through the supply chain yet) * Market competitive position and pressures Cost of Goods Sold has changed in relation to sales revenue... * Power within the supply chain * Change in supplier or production efficiency Changes in prices of particular commodity inputs 3) RETURN ON ASSETS Return generated by the assets for those who funded the assets. Insight into success of management in income generating asset allocation and utilisation. Return on Assets Formula: Return on Assets = (Income beforeTax + Interest Expense) / ((Assets at Start of Period + Assets at End of Period) / 2) Where do we find the Required Inputs? Income before Tax: From the Income Statement Interest Expense: From the Income Statement Assets at Start of Period: From the Previous Balance Sheet Assets at End of Period: From the Current Balance Sheet How to Interpret Changes in the Ratio: Profitability has changed in relation to the level of assets... * Management is getting ‘more from less’ in regards to assets * Management has made good asset allocation decisions in terms of revenue * Management has good control of costs in relation to expenses Previously mentioned reasons: e.g. economy, market power, competitive position Level of assets have changed in relation to profitability... * Assets may have suddenly increased through large, recent * CapEx Assets may not be being replaced or replenished at the same rate * Particular choice of depreciation/amortisation policies 4) RETURN ON EQUITY Return generated for the owners of the business, the common stockholders. Insight into success of any leverage used (when comparing to return on assets). Return on Equity Formula: Return on Equity = (Net Income - Preference Dividends) / ((Common Stockholder Equity at Start of Period + Common Stockholder Equity at End of Period) / 2) Where do we find the Required Inputs? Net Income: From the Income Statement Preference Dividends: From the Income Statement or Investor Relations Equity at Start of Period: From the Previous Balance Sheet Equity at End of Period: From the Current Balance Sheet How to Interpret Changes in the Ratio: Profitability has changed in relation to the level of common stockholder equity... * Management performance is changing in the eyes of, and on behalf of, the owners/employers * Previously mentioned reasons: e.g. economy, market power, competitive position, cost control, asset utilisation Common Stockholder Equity has changed in relation to profitability... * The level of liabilities have changed (and thus equity) * A stock issue or stock buyback (i.e. equity levels have changed) Subscribe to the Channel: https://goo.gl/84Sfeg Or just check out the Channel Page: https://goo.gl/yTj9Bs Most Popular YouTube Video: https://goo.gl/Jbv685 Latest YouTube Upload: https://goo.gl/wDM83Y 1) Website http://www.accofina.com 2) Amazon Author Page: http://www.amazon.com/author/axeltracy 3) Udemy Instructor Page https://www.udemy.com/u/axeltracy/ 4) Twitter http://www.twitter.com/accofina 5) Google+ http://plus.google.com/+accofina 6) Instagram https://www.instagram.com/axel_accofina/ 7) Facebook Page https://www.facebook.com/AccoFina.Page #Accounting #FinancialEducation #FundamentalAnalysis
Html code for embedding videos on your blog
Text Comments (33)
Lorena Kok (2 years ago)
Oh god I've been dying in my finances class. I wished I had seen this video earlier. So easy to understand! <3 thank you so much
AccoFina (2 years ago)
Thanks for the great comment, Lorena. I'm very happy you got value from the tut. That makes my day! Cheers, Axel
xasan siyaad (5 months ago)
that is good one
AccoFina (5 months ago)
Thanks mate!
Kamlesh Bhatiya (7 months ago)
Any other video is available for profitability analysis
AccoFina (7 months ago)
Hi Kamlesh. My channel doesn't yet have any other Profitability Analysis videos, specifically. But I'll make a note that this type of video is in demand, and this will influence future video production. I'm sorry I can't offer more now, you might have to try another Channel at this stage. Kind regards, Axel
Tatenda Nharo (2 years ago)
This is awesome! Best explanation I have ever received.
AccoFina (2 years ago)
Wow, thanks! I'm glad it helped, mate :-)
Incredible DJs (2 years ago)
Great content! Keep it up.
AccoFina (2 years ago)
Thanks mate, glad I could help.
Vozári Vajk (2 years ago)
Really good, and easy to follow, thank you! 1 question, how does Return on Capital employed differ from Return on Equity?
AccoFina (7 months ago)
No problems :-)
Vozári Vajk (2 years ago)
yeah, i understand, thanks for your reply :)
AccoFina (6 months ago)
Thanks for the positive feedback, mate! As for your question: ROE is (in it&#39;s simplest terms) Net Income / Stockholder Equity. Return on Capital Employed [ROCE] (a ratio I personally haven&#39;t used that much yet) is EBIT / Capital Employed, where EBIT is Net Income + Interest + Tax and Capital Employed is Stockholder Equity + NonCurrent Liabilities. So ROCE removes Interest (a debt financing decision outcome) and Tax (a government(s) decision outcome) on the numerator and then adds Non-Current Liabilities (the other source of long-term capital outside of equity) to the denominator. As mentioned, I&#39;m not yet too experienced in applying ROCE so I wouldn&#39;t want to misguide you by asserting any advantages or disadvantages between the two ratios. I hope this is okay and this reply will suffice. Best wishes, Axel November 2018 EDIT: While I'm still less familiar with ROCE, if I were to make an assumption about differences in interpreting the two... ROE would be a performance measure based for shareholders ...it's the return on what shareholders have put into the company. ROCE would be more likely used by management ...this is because it's a performance measure based on both forms of financing (debt and equity), while also stripping out some of the factors that management doesn't have control over (i.e. management doesn't want to be judged on interest expense or tax when they don't control interest rates or tax rates). Hope this helps a liitle more. Cheers, Axel
Alice Tetley (2 years ago)
Awesome lecture, thank you! Very clear and easy to follow.
AccoFina (2 years ago)
Thanks, Alice, much appreciated! I'm very happy you enjoyed the video and your comment has brought a big smile to my face. Best of success!
Megamind Zain (2 years ago)
AccoFina (2 years ago)
Thanks :-)
Partial (2 years ago)
this saved my life, thank you so much
AccoFina (2 years ago)
Glad I could help, mate. But don't get too stressed out about accounting & finances...I didn't save your life :-D . But still, thanks for the positive feedback, it means a lot. Cheers, Axel
aadithya sethunath (3 years ago)
Just a quick question. Can the GPM be a negative figure and how do we interpret this
AccoFina (3 years ago)
Hi again, in response to your assignment I must say, Shell is no ordinary business like a small electronics retailer or junior oil company. Shell's immense asset base and financial credibility means that it can possibly have negative profitability ratios for much longer than a standard business. I said that negative gross profit margins must only be short term, and while one would always want them to be better, a business only fails when it runs out of cash. Shell has a huge asset base (which could be sold) to raise cash and their immense history, size and financial credibility means that they could raise both debt or equity capital for more cash. Thus, Shell can last much longer with a negative gross profit margin than most businesses. I hope this helps further. Cheers, Axel
aadithya sethunath (3 years ago)
+accofina.com Im doing an assignment on shell and all their profit ratios are negative and this really helps me interpret it better. Thanks mate
AccoFina (3 years ago)
+aadithya sethunath Hi mate, In theory, yes it can be negative but it is not very common. For example, would an electronics retailer purchase TVs from a supplier for $300 each and then sell them to the customer for $250...and do this often enough that in the income statement the COGS figure is higher than revenue, in aggregate over the full period? This would be quite rare. There are a couple of exceptions: 1) Perhaps it is a marketing strategy to attract market share 2) Perhaps the business sells commodity based products and is a price-taker. Maybe their input costs (the COGS) as a manufacturer or primary producer are fixed, but the final sales price of the commodity product are falling globally. Think about the oil companies that are struggling at the moment with the falling crude price. They may have drilled for oil when it was $90/barrel and could extract the oil for $70/barrel. Now oil is about $50 and it still costs them $70/barrel to get it out of the ground. Whatever the case, it is rare. What should we interpret from it? a) We would need to investigate why COGS is so high or revenue is so low. b) We would hope that this phenomenon is temporary, because very few businesses can survive long-term in this situation. After all, they still need to pay all the operating expenses beyond the COGS....plus, ideally, a return to shareholders. c) The business will need to reduce it's COGS asap, or it may be forced to increase prices and thus lose market share (Does the business have this level of control in their operations & industry? You would need to consider this too). Overall, Yes it can happen, but it's a very bad sign for the business unless the situation is very short-term. I hope this helps. Cheers, Axel
Gigi Gi (3 years ago)
Many people said that average P/E ratio in the market has been around 15-25. Why has the average P/E ratio in the market been around 15-25? How do we define the average P/E ratio? Who define the average P/E ratio in the market around 15-25? If the average P/E Ratio is 15-25, it means that we need to wait for 15-25 years to cover our principle capital, which is not short period. Why is it a fair value and stable industry if P/E ratio is 15-25?
AccoFina (3 years ago)
+Gigi Gi Hi Gigi, 1) Average P/E of 15-25 is based on what shareholders are prepared for earnings, on average in the market. It is based on historical valuation concepts and has changed dramatically over the full history of the stock market. 2) Average market P/E ratio is based on the individual P/E ratios of every stock on the market, and then averaged. 3) I don't understand this question exactly, if you mean what I think you mean, then it's normally market commentators and analysts who discuss average P/E's 4) While I wouldn't put it that way myself, yes! If the P/E ratio is 25 then it will take 25 years for accumulated EPS to be equivalent to the stock price we paid. However, this is based on the assumption that EPS is constant over that 25 years...it is often the case that companies with high P/E's are considered 'growth' companies and thus their EPS may grow quite fast and make it quicker than 25 years. 5) I don't necessarily agree with this proposition. Finding a 100% accurate 'fair value' is based on many aspects of financial statement and market analysis and not only on a P/E ratio. Secondly, using a P/E ratio to determine a 'stable' industry is also not always a suitable method. While extreme market P/E levels may describe bubbles or troughs, throughout history and across geographies and industries there have been a very wide variety of average P/E's. I hope this helps, Axel
Gigi Gi (3 years ago)
EPS =( Net income - preferred dividend) / number of share outstanding  I don’t understand that why preferred dividend must be deducted for calculating EPS.  Why isn’t the formula be just net income / number of share outstanding?
AccoFina (3 years ago)
+Gigi Gi Hi Gigi, You remove the preferred dividend because: 1) You divide the numerator by the number of common (or ordinary) shares outstanding, and this does not include preferred shares or stock. Thus you wouldn't want to include the part of net income that is bound to go to a separate class of stockholders (the preferred stockholders). 2) Preferred stock is often regarded as an odd mix between equity and debt, so when EPS is a pure equity performance measure then you need to remove the debt-like aspect. After all, most people buy common stock based on the EPS figure and, once again, you have to remove the debt-like, bound payment to another class of stockholders that you would not be buying. I hope this helps. Get in contact again if you still find it confusing, I have written this response off the top of my head, so I'm happy to do a bit more research and offer a more comprehensive response. Cheers, Axel
Jj Jj (3 years ago)
Is profitability ratio analysis only done for profit making company?  If the company is loss company, does it mean that we do not need to do that profitability ratio analysis?
AccoFina (3 years ago)
+Joan Joan Hi again Joan! Yes, profitability ratio analysis should be done on all companies, even those that make a loss. The ratios outlined in this video still work for loss making companies, they will just be negative/minus results. As an example as to why profitability ratio analysis is still useful in loss making companies: Take Company A... it has a Return on Equity for three years of -30% then -35% then finally -45%. Now take Company B... it has a Return on Equity of -30% then -20% and then finally -5%. You see both have all negative ROE results due to losses, but doesn't Company B look more appealing? It has an improving ROE (although still negative) and if the trend continues will soon have a positive ROE. So from using profitability ratio analysis on loss making Company A and B we can see (through one ratio alone) that Company B is a more attractive business. I hope this helps. Kind regards, Axel
Jj Jj (4 years ago)
Why do bankers need to look at the share price of the company?
AccoFina (4 years ago)
+Joan Joan Hi Joan, thanks for the question.  You will find that bankers (when deciding on whether to lend money) are more interested in the income statement (for loan serviceability) and the balance sheet (for security) rather than the share price. It is investors and management who would be more interested in the share price. This is just a quick & general answer but I hope it helps. If you need anything more specific, just add a bit more detail to the question. Kind regards, Axel @ accofina
AccoFina (6 months ago)
First comment with new video! Get in contact or comment with any feedback. Also get in touch if you need any further support or clarification in regards to this video. And if you did enjoy the video please Share or Thumbs Up, or better yet: Please Subscribe at youtube.com/accofina or Visit accofina.com direct. Best wishes, Axel

Would you like to comment?

Join YouTube for a free account, or sign in if you are already a member.