Financial Analysis:
Things which we should to consider before invest in any stock….
Fundamental analysis
Profitability Ratios
The Profitability ratios help the analyst measure the profitability of the company. The ratios convey how well the company is able to perform in terms of generating profits. Profitability of a company also signals the competitiveness of the management. As the profits are needed for business expansion and to pay dividends to its shareholders a company’s profitability is an important consideration for the shareholders.
The profitability ratios, also known as performance ratios, assesses the firm`s ability to earn profits on sales, assets and equity. These are critical to determining the attractiveness of investing in company shares, and investors use these ratios widely. We will examine five important profitability ratios, namely, gross profit margin, operating profit margin, net profit margin, return on assets, and return on equity.
1. Gross Profit Margin
| Sales – Cost of Goods Sold |
The gross profit margin (GPM) shows the firm`s profit margin after deducting costs of goods sold but before deducting operating expenses, interest expenses, and taxes.This ratio is also known as gross profit ratio.
Gross Profit Margin =
This is the first level of profitability. The GPM depends primarily on the firm`s product pricing and cost control. The price of the product impacts sales. Production cost such as material, labour, and overhead or the cost of purchases affect the cost of goods sold. A firm with a better ability to price products in line with inflation of cost of production and the ability to control production costs or suppliers will be able to maintain or increase gross margins.
2. Operating Profit margin
| EBIT / SALES |
The operating profit margin (OPM) shows the firm`s profit margin after deducting cost of goods sold and operating expenses but before interest expenses and taxes. The operating profit is the earnings before interest and taxes or EBIT as a percent of ales.
Operating Profit margin =
The OPM reflects the true profitability of firm`s business in that it is calculated before deducting interest costs, which are a result from firm`s financing decision, and taxes, which are outside the control of the firm. In other words, regardless of the way the firm is financed, whether through debt or equity, and regardless of the taxes imposed by the government, the firm is able to earn this margin.
3. Net Profit Margin
| Net Income / Sales |
This is the bottom-line profitability, which most analysts and investors pay attention to on a regular basis. The net profit margin (NPM) shows the firm`s profit margin after all the costs and expenses. It is the profit available for distribution to common shareholders a percentage of sales.
Net Profit margin =
Obviously, the lower operating profit margin is one reason for the lower NPM. It is also possible that, since the firm is more debt-financed than an average firm, it has more interest expenses as well. Since taxes are fixed, the key difference between the OPM and NPM is interest costs, which are linked to the firm`s financing decision.
4. Return on assets
The return on assets (ROA) measures the return earned on total assets employed in the business. Sometimes, this is also referred to as the return on total capital. Since total assets are financed through both debt and equity, is important that the return measure used for this calculation reflects income to both shareholders and debt holders. We define the return as the net income available for distribution to shareholders plus the interest expenses paid to debt holders. This return is divided by the average total assets, which represents the simple average of the total assets at the beginning and ending balance sheets.
| Net Income + Interest Expenses / Average Total Assets |
Return on assets =
5. Return on Equity
The return on equity (ROE) measures the return earned on the capital provided by the common stockholders (Equity holders). It is the net income as a percent of the average common equity, where the average common equity is the simple average of the common equity at the beginning and ending balance sheets. The net income is the income available for distribution to ordinary shareholders after deducting any preferred dividends.
| Net Income /Average Common Equity |
ROE =
Leverage Ratios
The leverage ratios, also called debt management ratios, measure two key aspects of the use of debt financing by the firm. The use of debt financing a called financial leverage. We want to know the level of financial leverage used by the business as well as the ability of the firm to service its debt obligations. The debt ratio, debt-equity ratio and interest cover is discussed below.
1. Debt Ratio
The debt ratio indicates the proportion of assets financed through both short-term and longterm debt. This ratio is computed as total debt, which is the sum of short-term and long-term debt, as a percentage of total assets. A higher ration indicates higher leverage. A higher ration also means lower debt capacity in that the ability for the firm to raise funds through more debt is lower due to already high debt levels.
| Total Debt / Total Assets |
Debt Ratio =
2. Debt – Equity Ratio
| Long Term Debt /Total Equity |
The debt to equity ratio (D/E) is also widely used as an indication of the level of financial leverage. While there are several ways of computing this ratio, the most useful version is to express long term debt as percent of total equity. Thus it focuses only on the long-term financing, both debt and equity, and it is meaningful when we want to examine the long-term leverage. Total equity includes both preferred equity and common equity. A higher debt equity ratio indicates greater leverage and potentially higher financial risk.
Debt – Equity Ratio =
3. Interest Cover
Technical analysis
