Using Historical Data To Determine The Profitability Of A Company
Where the results of the business are not yielding profit for a long period of time without any clear route to redemption, the long term objective of your investment will also not be satisfied.
One of the easiest and most important metrics by which we determine the success of a company is its profitability. As long as it isn’t a not-for-profit company, a key goal of its existence is tied to its profitability.
Where a company is not making a profit, its operations will not be sustainable as it might need to depend on debt to finance its operations. As an investor, your money is put in use to finance a business and propel it towards growth.
Where the results of the business are not yielding profit for a long period of time without any clear route to redemption, the long term objective of your investment will also not be satisfied.
An easy way to determine the profitability potential of any company or stock before you invest is to assess their historical financial statements and compute the relevant ratios. The following are some of the ratios to compute and what they mean for any company.
Gross Profit Margin
Gross profit represents the profit that a business makes after its unavoidable expenses have been subtracted from the total revenue made. For example, in a situation where a company makes shoes, the company cannot make revenue or sell anything without first investing in obtaining the raw materials and direct labour required to make the shoes.
To determine the gross profit margin, divide the gross profit (Revenue minus ‘cost of goods sold’) by the revenue for a given period. That is, Gross profit/Revenue x 100. The percentage answer derived will show you how much money the company spends on direct cost and the profit.
If the gross profit margin is too low, then the business might not be too profitable as it costs too much to produce even before subtracting operating expenses.
Net Profit Margin
This is the profit margin of the business. This is computed by dividing net profit by total revenue. That is, Net profit/Revenue. Net profit is determined by subtracting all expenses from revenue.
In addition to the direct cost of goods sold as above, it also deducts depreciation, operating expenses, administrative expenses and so on. There can be various variations of this.
Where you want to account for profit without accounting for non-cash things like depreciation or amortization as well as interest or taxation, you subtract everything else but these items to derive Earnings Before interest tax and depreciation (EBITDA).
EBITDA Margin is EBITDA/Revenue x 100. The resulting ratio or percentage of your Net profit Margin might show you why the company doesn’t pay dividends. Is it ploughing back its profits to reinvest in the business for growth or is it not just making enough profits at all?
This computation will help you determine that. You can also make use of industry standards to determine a benchmark and aid comparison.
Other tools exist to guide the investor on the viability of a stock or a company. They will be discussed in later articles.
Written by Lawretta Egba.