Net Profit Margin Ratio

The net profit margin ratio is defined as:

Net profit / Net sales

Take the case of a firm Horizon’s net profit margin ratio for 20X1 is:

34 / 701 = 0.049 m that is 4.9 percent

This ratio shows the earnings left for shareholders (both equity and preference) as a percentage of net sales. It measures the overall efficiency of production, administration, selling, financing, pricing and tax management. Jointly considered, the gross and net profit margin ratios provide a valuable understanding of the cost and profit structure of the firm and enable the analysts to identify the sources of business efficiency / inefficiency.

Return on Assets: The return on assets (ROA) is defined as:

ROA = Profit after tax / Average total assets

Horizon’s ROA for the year 20X1 is:

34 ÷ [(412 + 474) / 2] = 7.7 percent

Though widely used, ROA is an odd measure because its numerator measures the return to shareholders (equity and preference) whereas its denominator represents the contribution of all investors (share holders as well as lenders).

Earning Power: The earning power is defined as:

Earning power = Profit before interests and tax / Average total Assets

Horizon’s earning power for the year 20X1 is:

89 ÷ [(412 + 474) / 2] = 0.201 or 20.1 percent

Earning powers is a measure of business performance which is not affected by interest charges and tax burden. It abstracts away the effect of capital structure and tax factor and focuses on operating performance, hence it is eminently suited for inter firm comparison. Further, it is internally consistent. The numerator represents a measure of pre tax earnings belonging to all sources of finance and the denominator represents total financing.

Return on capital Employed: The return on capital employed is defined as:

ROCE = Profit before interest and tax (1 – Tax rate) / Average total assets

The numerator of this ratio viz., profit before interest and tax (1 – tax rate) is also called net operating profit after tax (NOPAT).

Horizon’s ROCE for the year 20X1 is:

89 (1 – 0.5) ÷ [(412 + 474) / 2] = 0.101 or 10.1 percent.

ROCE is the post tax version of earning power. It considers the effect of taxation, but not the capital structure. It is internally consistent. Its merit is that it is defined in such a way that it can be compared directly with the post tax weighted average cost of capital of the firm.

Return on Equity: A measure of great interest to equity shareholders, the return on equity is defined as:

Equity earnings / Average equity

The numerator of this ratio is equal to profit after tax less preferences dividends. The denominator includes all contributions made by equity shareholders (paid up capital + reserves and surplus).The ratio is also called the return on net worth.

34 ÷ {(262 + 256) / 2] = 0.131 or 13.1 percent

The return on equity measures the profitability of equity funds invested in the firm. It is regarded as a very important measure because it reflects the productivity of the ownership (or risk) capital employed in the firm. It is influenced by several factors: earning power, debt equity ratio, average cost of debt funds, and tax rate.

In judging all the profitability measures it should be borne in mind that the historical valuation of assets imparts an upward bias to profitability measures during an inflationary period. This happens because the numerator of these measures represents current values, whereas the denominator represents historical values.

Valuation ratios:

Valuation ratios indicate how the equity stock of the company is assesses in the capital market. Since the market value of equity reflects the combined influence of risk and return, valuation ratios are the most comprehensive measures of a firm’s performance. The important valuation ratios are: price earning ratio, yield and market value to book value ratio.