Question

There are different categories of ratio analysis: liquidity, activity, profitability and leverage. Which category would be the most important to potential investors?  

Answer 1

As from the Potential Investor’s point of view all categories of financial ratios are considered to be important as to know the share in which Investor going to invest in have capability to earn more & provide growth with lesser risk to the amount invested. But out of them the most Important Category can be said to be the Profitability Ratio which every Potential Investor will look into before Investing in the Company’s Share.

Profitability Ratio is a key piece of information that should be analysed when a Potential Investor considering investing in a company. This is because high Revenue alone don’t necessarily translate into dividends for investors (or increased stock prices, for that matter) unless a company is able to clear all of its expenses and costs.

Profitability ratios are used to give us an idea of how likely it is the company will turn a profit, as well as how the profit relates to other important information about the company.

Few examples of most important profitability ratios are as follows:

1. Net Profit Margin: Net Profit X 100 / Revenue, at least 7% or more would be considered safe and higher the better;
2. Return on Equity: Net Income after Tax X 100 / Average Shareholder Equity, at least 10% considered safe & satisfactory and between 10 to 15% considered good;
3. Earnings Per Share: Earnings available to common shareholders / No. of outstanding Shares, A higher EPS means that a company is profitable enough to pay out more money to its shareholders;
4. Return on Capital Employed: EBIT or Net Operating Profit X 100 / Capital Employed, A higher RoCE indicates more efficient use of Capital Employed, RoCE should be higher than the company’s Capital Cost;

In general, the higher a company’s profitability ratio, the better, but as with most ratios, it is not enough to look at in isolation. It is important to compare it to the company's past levels, to the market average and to its competitors.

There are a couple of red flags you should watch out for with the profit margin, especially where the company is seeing decreasing profit margins year-over-year. This can suggest changing market conditions or where the company is seeing increasing competition or rising costs. Also, if a company's profit margin is out of line compared to the rest of its industry, it is worth the extra effort to find out why.

If a company has a really low profit margin, it could mean it will land in a bad position if market conditions change. A really high profit margin relative to the industry could mean that the company has arrangements or advantages that might not last.