Learning how to identify the profitability of a firm can be important in terms of reviewing the long-term financial health of companies you are considering for investment. Companies that are not earning a profit are forced to raise capital from stock or bondholders. While most companies can successfully operate with losses for a short period of time, at some point stakeholders will demand a return on their money.
While there are several methods of calculating profit margins, the two primarily used are Operating and Net profit margins. The primary difference between the two calculations relates to which expenses are included in the calculation. Operating profit margins focus on the firm's ability to turn a profit from operations; it excludes other expenses not directly related to the daily operations of the company.
Operating Profit Margin = revenue - (cost of goods sold + selling and general administrative expenses) / revenue
Net Profit Margin = net income / revenue
Net income is the amount of money left to the firm after all expenses including taxes that have been paid.
Turnover ratios help you understand how quickly the company can turn assets into revenue. Every industry has its own standard for what is acceptable, but on average, the higher the number the quicker the firm can turn assets into revenue.
An additional reason for monitoring turnover figures is that it can act as a red flag to the quality of the company's earnings and management decisions. As an example, retailers that make bad purchasing decisions may have to have to discount their inventories in order to induce sales of their products. Because of the discounts, you will often see minimal difference in the growth of sales while seeing a visible increase in the turnover levels for inventories. The most commonly used turnover ratios are the Asset turnover and Inventory turnover ratio. The calculations are as follows:
Asset Turnover Ratio = revenue / average total assets
Inventory Turnover Ratio = revenue / average inventory
The following calculation may also be used:
Inventory Turnover Ratio = cost of goods / average inventory
Ratios are reported using the average report assets over the course two reporting periods. Often they are the average assets or inventories over the course of the year or from one quarter to another quarter.
The strategies described in this article are for information purposes only, and their use does not guarantee a profit. None of the information provided should be considered a recommendation or solicitation to invest in, or liquidate, a particular security or type of security. Investors should fully research any security before making an investment decision. Securities are subject to market fluctuation and may lose value.