The most common thought among business owners, consultants, investors and students is the ‘bottom line’. The proper word is of course ‘PROFIT’. In business, the single number one reason to operate is to make a profit. To start, there are three reasons to be in business:
- Make a profit,
- Provide long-term security for employees, and
- Satisfy the consumer.
Take note, making a profit is the primary purpose. Without profit, the company will fail to return money back to the investors via dividends and reduce risk for all parties involved. Risk reduction includes reducing debt, expanding operations and/or improving the product/service lines.
Performance ratios measure the ability of the company to achieve those three goals. Performance ratios consist of:
The first three measure the income statement relationships for the three basic sections. If you look at a basic income statement (profit and loss), you will find the layout as follows:
Revenue (Sales) $ZZ,ZZZ,ZZZ
Cost of Sales ZZ,ZZZ,ZZZ
Gross Profit Z,ZZZ,ZZZ
Operational Profit Z,ZZZ,ZZZ
Deprec./Amort. & Taxes Z,ZZZ,ZZZ
Net Profit $Z,ZZZ,ZZZ
All three profit points reflect the first three performance ratios. The ratios are a percentage of revenue. Gross profit should have a higher percentage than operational and operational is customarily higher than the net profit margin. These relationships tell the investor how well the company is performing financially related to actual operations. At anytime, if the profit point in the report is negative, it is a sign to the reader to investigate further to determine the contributing factors. But the traditional outcome is always a stepping down of percentages, whereby the bottom line is a positive percentage of revenue. Of course, the greater the net profit percentage the greater the performance of the company.
The last two performance ratios tell the investor how well the company is doing utilizing the existing equity and total assets. The ratio formulas are the net profit earned during the period divided by the respective beginning balance of either equity or total assets. Since equity is a function of total assets less total liabilities, its ratio outcome will always be greater than the return on assets result.
In the overall ratio hierarchy, performance ratios carry greater weight than the other ratio groups. Why? Well, performance ratios measure what the company actually does, not how the market perceives the company (valuation ratios). The other ratio groups measure the relationships between the income statement and the balance sheet. Performance ratios focus on what the company does as a business. As an investor, you want to know the value of how well the company performs financially selling its product and/or services.
Of all the performance ratios, the gross profit margin is the most critical and should have the greatest importance of all the ratios. This single ratio really tells the story of how well the company compares to its competition. As stated many times throughout this business ratio series, it is important to only compare the ratio against similar industry entities. You can’t compare retail against transportation nor retail against utilities. Here is an example of some industries and some noted companies and their gross profit margin.
- Walmart (Retail) – 25.10%
- Duke Energy (Utilities) – 27.44%
- Union Pacific (Transportation) – 41.78%
- Verizon (Communications) – 44.52%
- Camden Property Trust (Real Estate) – 29.57%
As an investor, you must discover the zone or endpoints of the gross profit margin for the respective industry you invest. You can not compare one industry against another, Walmart is the largest traditional retailer in the world. Walmart’s annual sales exceed $510 Billion per year. A 25% profit margin means they are generating more than $100 Billion in contribution before traditional general and administrative costs. Whereas Camden has sales of $957 Million (about .2% of Walmart’s sales) yet Camden has a higher percentage of gross profit margin. Verizon has sales of $131 Billion and has a gross profit of $58.32 Billion. As an investor, it is important to understand this relationship and of course the importance of only comparing similar businesses.
The respective chapters in this section covering these ratios explain the respective formula and the proper application. In addition, an investor has to use similar sourced values or the investor will end up with misleading results. Following up from the gross profit margin relationship example above, retail defines cost of sales differently than transportation. Transportation and real estate are highly dependent on fixed assets to deliver the service they provide. Thus, cost of sales includes the operational costs of those assets. In retail, it is inventory based, thus the formula for cost of sales is significantly different. Understanding these nuances separates the investor from others and allows them to exercise this knowledge and put this information to good use by investing based on good comparative information.
As stated above and reiterated here, performance ratios should carry the greatest weight in your decision model. In the author’s opinion, performance ratios should exceed 30% of the total decision value and in many instances will approach 50%. However, even though performance is important, it doesn’t necessarily mean that the company is doing well. The other ratios provide the necessary information to the readers of how well the management team administers the company’s assets and ability to properly utilize debt (leverage ratios) to reduce risk and increase performance. Therefore, keep the weighted value of performance ratios between 30% and 50%. Always tend towards the 50% level than the 30% level. However, as the entity is more asset intensive such as real estate, the performance ratios should total no more than 40% weighted value. Asset intensive businesses are customarily stable and thus, the leverage ratios become more important with this group of industries. ACT ON KNOWLEDGE.