Profitability and debt: margins, ROE and leverage
A good company doesn't just sell a lot: it keeps a good share of what it sells and doesn't depend on debt to survive. How to measure it.
Two companies can sell the same and be very different businesses. One may keep 30 cents of every dollar it sells and the other 2. One may fund itself with its own profits and the other depend on borrowing every year. A business's quality shows in its profitability and its debt.
Margins
| Margin | How it's calculated | What it tells you |
|---|---|---|
| Gross | Gross profit ÷ sales | What's left after producing; reflects pricing power |
| Operating | Operating profit ÷ sales | What the business itself earns |
| Net | Net income ÷ sales | What's left for shareholders |
Normal margins vary a lot by industry: a supermarket can have a 3% net margin and be a great business because of its volume; a software company can have 30%. Always compare against companies in the same sector and watch the trend: rising margins usually point to an edge over competitors.
Return on equity (ROE)
ROE = net income ÷ shareholders' equity
It measures how much the company earns for every dollar its shareholders have put in (or left in). An ROE of 15% means that, with equity of 800, it earns 120 a year. A high, stable ROE over years is usually a sign of a good business.
Return on invested capital (ROIC)
ROIC compares operating profit (after taxes) with all the capital invested in the business, whether from shareholders or debt. Since it doesn't depend on how the company is financed, many analysts prefer it to ROE. If ROIC is higher than what that capital costs the company, it's creating value.
Debt: useful up to a point
Debt isn't bad in itself: it allows faster growth. But it requires paying interest no matter what, and in a bad year it can sink the company. Some common measures:
| Measure | How it's calculated | General reading |
|---|---|---|
| Net debt / EBITDA | (Debt − cash) ÷ EBITDA | Under 2 is usually comfortable; over 4, high (depends on the sector) |
| Interest coverage | Operating profit ÷ interest | How many times profit covers interest |
| Debt / equity | Total debt ÷ shareholders' equity | How much it's financed by debt versus its owners |
| Current ratio | Current assets ÷ current liabilities | Whether it can pay what comes due within the year |
Competitive advantages
High margins and high ROE only last if the company has something competitors can't easily copy: a strong brand, network effects (more users make the product more valuable), lower costs from its scale, high switching costs for its customers or patents. This is called a "moat".
Test what you learned
1. A company has net income of 120 and equity of 800. What's its ROE?
- 15%
- 12%
- 6.7%
Show the answer
15%. 120 ÷ 800 = 15%.
2. Why check ROE together with debt?
- Because debt can inflate ROE
- Because debt always lowers ROE
- They're unrelated
Show the answer
Because debt can inflate ROE. With a lot of debt, equity is small and ROE looks higher.
3. Net debt of 600 and EBITDA of 150. What's its net debt / EBITDA?
- 2
- 4
- 0.25
Show the answer
4. 600 ÷ 150 = 4: a high level in many sectors.
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