05 December 2012

Introducing Simple Financial Ratio - Part 2

From my previous post Introducing Simple Financial Ratio - Part 1, I have introduced some simple financial Ratio such as P/E Ratio, P/B Ratio, D/Y Ratio and ROE. Today I am going to introduce more financial ratio which I think is useful to the retail investors.

Gross Profit Margin = Gross Profit / Revenue

The Gross Profit is derived from Revenue minus from the Cost of Good Sold. If you position yourself as a business owner, then you will likely to hope that your gross profit margin can be as high as possible, as this is the first step you can try to achieve a better return from the services/products you sell to your clients.

Different sectors would have different range of gross profit margin. For example, Food & Beverage Industry sectors normally enjoy a better gross profit margin compared to Commodities Trading Industry sectors. This is due to the business model they are leveraging on as well as the value they provide to the clients are from "Services" or from "Products". A software development company normally would enjoy a better gross profit margin as they rely most on creativity which consumes more on Man Brain Power instead of the material they need to provide the products to the clients.

The more so called "Intangible Assets or Goodwill" the company has, the higher gross profit margin they can enjoy. Take for example, Nestle is a global branding company which involves in a lot of dairy consumer products such as milk powder and so on. They could enjoy a better gross profit margin after they are the market leader as well as willing to pump more money in R&D and Marketing campaign to create a different and better products to wider range of clients.

Net Profit Margin = Net Profit / Revenue

Net profit is the profit after net off all the expenses incurred during the sales process, such as Cost of Good Sold, Interest Expenses, Tax Expenses, Other Non Recurring Expenses and Other Recurring Expenses etc.  The better Net Profit Margin compared to the peers, the better the company is. Of course, we could analyze further how the net profit is derived from to make sure the quality of the net profit is not due to manipulation from the management. I will use another post to show you how to try to identify the possibility of the manipulation of management.

Net Profit Margin is another important indicator to allow you to check on the trend of the business model of the company, or the trend of the sector it is currently in. For example, a rising net profit margin indicating that the previous expenses in marketing and R&D has started to generate better income or create a higher gross profit margin products/services rendered to the clients. A dropping net profit margin could indicate higher expenses in Interest Rate Payment / Tax Payment / Marketing Expenses / R&D Expenses etc due to tougher economy condition or just because of a one off Non Recurring Expenses. There are so many possibilities that we have to be more cautious in analyzing the net profit margin as compared to gross profit margin that I explained to you earlier.

Asset Turnover = Revenue / Assets 

This is a simplified version of Asset Turnover Ratio. In general, the better the Asset Turnover Ratio, the higher efficiency the company is. For example, if you compare two companies with different asset base - $100K and $200K each. If company A ($100K Asset Base) generates $300K revenue a year, which is same as company B ($200K Asset Base), then you can treat company A (Asset Turnover Ratio = 3) is better in managing their working capital as well as fixed assets to generate higher revenue as compared to company B (Asset Turnover Ratio = 1.5).

Asset Turnover Ratio is important indicator if you are comparing companies in same industry. But please be aware that some companies may rely on higher technology to generate more revenue, and some companies will still like to generate more revenue by relying on lower labor cost. The different business strategy the company applies to will result in different Asset Turnover Ratio.

Normally a company which has a better technology may generate higher revenue with current assets employed, as they do not really rely on increasing the labor costs (which indirectly increase the fixed assets - to purchase more machines and be used by the labors as well as the working capital). But they may also have another risk - they have to keep on improving their technology to ensure that they are not lagging behind the rest.

The other example of a company that enjoys better asset turnover ratio could be due to the high efficiency of the management. For example, Sheng Siong enjoys a higher asset turnover ratio, due to the reasons that they try to utilize fully the shop lot by placing more items to try to sell more items to the clients.

Equity Multiplier = Asset / Equity

Equity Multiplier is in management control to try to achieve optimal corporate finance structure by having the best debt and equity ratio. If you notice, if higher equity multiplier ratio the company has, the higher interest rate would be charged to it due to higher financial risk.

In another scenario, a no debt company maybe is treated as a conservative company or they just simply don't need/want to leverage on debt to grow their business. You may look at the applied bond yield to roughly calculate the cost of financing for a company to do their business.

Return On Asset Ratio (ROA) = Net Profit Margin * Asset Turnover

Of course, you may treat ROA as a more conservative ratio, if you do not like to take into consideration of the impact of Equity Multiplier. Always remember to compare ROA or ROE ratio with peers,  so that you can always know which company can enjoy competitive advantage ( and what kind of competitive advantage they have) compared to peers.

For example, if you are comparing REITs, you may find out the ROA of REITs of different country / different sectors could be different. So you have to compare Apple to Apple and not to mix it up to compare Apple with Orange.

Return On Equity Ratio (ROE) = Net Profit Margin * Asset Turnover * Equity Multiplier 

ROE is an important indicator for me to analyze whether the company is a good company. ROE is by far the most frequent indicator I use to analyze the company. The Higher ROE, the better the company quality. But we have to find out whether high ROE is due to which factors. If high ROE is because of the high Equity Multiplier, then we have to be aware of the underlying financial risk the company has.

Nonetheless, we also should check on the industry the company is in. For example, financial industry is having higher ROE due to the their business model which allows them to leverage on debt to generate better profit. This is one of the reasons why the financial industry can prosper during good times but leads to a series of bankruptcy when bad time comes.

You may treat a debt as a good debt or bad debt, depending on how the company is using it. In long run, the company has to achieve optimal corporate finance level to enjoy optimal cost of corporate finance to run their business.

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