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Corporate earnings are important to you as an investor. If you compare corporate earnings of prospective investments, you will make wiser investment decisions. Profitability ratios provide you with tools you can use to make these comparisons.
In this tutorial you will learn:
HOW DO I USE FUNDAMENTALS TO MAKE AN INVESTMENT DECISION?
Fundamental Analysis is a method used to evaluate the worth of a security by studying the financial data of the issuer. Performing fundamental analysis will teach you a lot about a company, but virtually nothing about how it will perform in the stock market. Apply this analysis on two competing companies and it becomes clearer which is the better investment choice. In this tutorial, you will learn to use some of the tools of the fundamental analyst.
As an investor, you are interested in a corporation's earnings because earnings provide you with potential dividends and growth. Companies with greater earnings pay higher dividends and have greater growth potential. You can use profitability ratios to compare earnings for prospective investments. Profitability ratios are measures of performance showing how much the firm is earning compared to its sales, assets or equity.
You can quickly see the difference in profitability between two companies by comparing the profitability ratios of each. Let us see how ratio analysis works.
WHAT IS RATIO ANALYSIS?
While a detailed explanation of ratio analysis is beyond the scope of this tutorial, we will focus on a technique, which is easy to use. It can provide you with a valuable investment analysis tool.
This technique is called cross-sectional analysis. Cross-sectional analysis compares financial ratios of several companies from the same industry. Ratio analysis can provide valuable information about a company's financial health. A financial ratio measures a company's performance in a specific area. For example, you could use a ratio of a company's debt to its equity to measure a company's leverage. By comparing the leverage ratios of two companies, you can determine which company uses greater debt in the conduct of its business. A company whose leverage ratio is higher than a competitor's has more debt per equity. You can use this information to make a judgment as to which company is a better investment risk.
However, you must be careful not to place too much importance on one ratio. You obtain a better indication of the direction in which a company is moving when several ratios are taken as a group.
WHAT CAN I LEARN FROM THE PROFITABILITY RATIOS?
The profitability ratios include: Operating Profit Margin, Net-Profit Margin, Return on Assets and Return on Equity.
Profit Margin measures how much a company earns relative to its sales. A company with a higher profit margin than its competitor is more efficient. There are two profit margin ratios. Operating Profit Margin measures the earnings before interest and taxes.
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| Operating Profit Margin = | Earnings before interest and taxes |
| Sales |
Net
Profit Margin measures earnings after taxes.
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| Net Profit Margin = | Earnings after taxes |
| Sales |
While it seems as if these both measure the same attribute, their results can be dramatically different due to the impact of interest and tax expenses. Similarly, the next two ratios appear to be similar but they tell different stories. As an investor, you are interested in getting a return on your investment. So is a corporation.
Return on Assets tells how well management is performing on all the firm's resources. However, it does not tell how well they are performing for the stockholders.
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| Return on Assets = | Earnings after taxes |
| Total Assets |
Return on Equity measures how well management is doing for you, the investor because it tell how much earnings they are getting for each of your invested dollars.
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| Return on Equity = | Earnings after taxes |
| Equity |
These ratios are easy to calculate and the information is readily available in a company's annual report. All you need do is review the income statement and balance sheet to come up with the data to plug into the formulas.
But, do not neglect other income statement information that can save you from making a costly mistake.
WHEN IS AN INCREASE IN EARNINGS A LOSS?
Sometimes an increase in company earnings can disguise an operating loss. If a company's operating expenses exceed its operating income, it has an operating loss. If it also has "income" from investments and tax benefits, this income can offset the loss and show an increase in earnings per share. However, if these other sources of non-operating income are not recurring, the unsuspecting investor may come to an erroneous conclusion about the company's overall financial health.
The lesson to be learned here is to carefully scrutinize the financials especially when operating income is negative.
HOW DO YOU USE YOUR KNOWLEDGE OF PROFITABILITY RATIOS TO MAKE INVESTMENT DECISIONS?
When considering a company as a prospective investment you should review its financial statements. Pay particular attention to the profitability ratios. If you can, calculate the ratios for the same company over several successive years to see if the company earnings are consistent, growing, or declining.
Compare your candidate's ratios to other companies in the same industry. This will help you determine where your candidate stands in the industry.
Do not ignore other financial information on the income statement and balance sheet. Pay particular attention to losses in income items.
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