Profits - Comparing Apples to Apples

Profits - Comparing Apples to Apples

Profits - Comparing Apples to Apples

One factor you should consider when you are comparing two or more companies is the profit margin ratio. An analysis of the company's historical ratios as well as an analysis of the company's ratios against ratios from the same industry should be done.Some of the more common profitability ratios include: operating profit margin, earnings before interest and tax (EBIT), earnings before interest, tax, depreciation, and amortization (EBITDA), return on assets (ROA), and return on equity (ROE). All of the ratios listed above can be calculated with the company's income statement also known as the profit & loss statement with the exception of the ROA and ROE ratios. You will also need to have the company's balance sheet. If the company doesn't have financial statements, you can find these numbers on its annual tax returns. To calculate operating profit, you divide the amount of operating profit by the same period's revenue. Here is an example. Revenue for 2009 was $1,000,000 and operating profit was $50,000. You divide $50,000 by $1,000,000 to get 0.05 or 5%. To get EBIT, you simple divide earnings before tax and interest by revenue. To get EBITDA you do the same calculation as EBIT but you also add depreciation and amortization expense to EBIT and then divide it by revenue. To calculate ROA, you divide the company's earnings by its total assets. To get ROE, you divide earnings by total capital also known as net worth. By looking at these ratios over a historic time period, let's say five years, you can see if the company's profits are getting stronger or weaker. You will also notice if profits are stable or unstable.Another analysis you should perform compares the company's ratios with its peers in the same industry. This type of comparison will tell you if the company is stronger, weaker, or average when compared to the rest of the companies in the industry.Suppose you were looking at a bakery which had an operating profit margin of 10% and you found out the industry average was 5%. The bakery's EBIT ratio was 12% while the industry's average EBIT ratio was 8%. Assuming the rest of the profitability ratios were similar, you would know the company has better profitability ratios than the average bakery in the industry; and you would expect it to be more valuable than the average bakery.Other ratios you should calculate and analyze include: liquidity ratios, turnover ratios, asset ratios, coverage ratios, net worth ratios, and leverage ratios.You can get in touch with trade associations in your industry to locate industry ratios for your analysis. Most of them are very useful and contain the data you require. You can also get information from companies that publish financial data on specific industries. A few of the more known publications include: RMA Annual Statement Studies, Troy's Almanac of Business and Industrial Financial Ratios, Financial Studies of the Small Business, D & B Industry Norms and Key Business Ratios, and S & P Industry Surveys.It still astonishes me to see someone apply a rule of thumb to determine the value of their business. By using a rule of thumb, they are saying all companies are the same. Some businesses are worth more than others. Analyzing the ratios mentioned above can help you determine if your business is worth more or less than the average business in your industry.

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