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Optimization of technical trading strategies and the profitability in security markets
Cordelia Amber Snow 3 years ago Views:
1 Economics Letters 59 (1998) Optimization of technical trading strategies and the profitability in security markets Ramazan Gençay 1, * University of Windsor, Department of Economics, 401 Sunset, Windsor ON, Canada N9B 3P4 Received 12 March 1997; received in revised form 25 November 1997; accepted 19 December 1997 Abstract The ultimate goal of any testing strategy is to measure profitability. This paper measures the profitability of simple technical trading rules based on nonparametric models which maximize the total returns of an investment strategy. The profitability of an investment strategy is evaluated against a simple buy-and-hold strategy on the security and its distance from the ideal net profit. The predictive performance is evaluated by the market timing tests of Henriksson-Merton and Pesaran-Timmermann to measure whether forecasts have economic value in practice. The results of an illustrative example indicate that nonparametric models with technical strategies provide significant profits when tested against buy-and-hold strategies. In addition, the sign predictions of these models are statistically significant Elsevier Science S.A. Keywords: Technical trading; Neural network models; Security markets JEL classification: G14; G10 1. Introduction Traders test historical data to establish specific rules for buying and selling securities with the objective of maximizing profit and minimizing risk of loss. Traders base their analysis on the premise that the patterns in market prices are assumed to recur in the future, and thus, these patterns can be used for predictive purposes. The motivation behind the technical analysis is to be able to identify changes in trends at an early stage and to maintain an investment strategy until the weight of the evidence indicates that the trend has reversed. The earlier literature on stock returns finds evidence that daily, weekly and monthly returns are predictable from past returns. Pesaran and Timmermann (1994) present further recent evidence on the predictability of excess returns on common stocks for the Standard and Poor s 500 and the Dow Jones *Corresponding author. Tel.: ; fax: ; 1 I thank the participants at CIRANO, Montreal for the Workshop on Neural Networks Applications to Finance, September 13 16, 1996 and the 12th Canadian International Futures and Options Conference, Montreal, September 16 17, I also thank the Natural Sciences and Engineering Research Council of Canada and the Social Sciences and Humanities Research Council of Canada for financial support. Mailing address: Department of Economics, University of Windsor, 401 Sunset, Windsor, Ontario N9B 3P4, Canada. Fax: (519) , / 98/ $ Elsevier Science S.A. All rights reserved. PII: S (98)
2 250 R. Gençay / Economics Letters 59 (1998) Industrial portfolios at the monthly, quarterly and annual frequencies. Pesaran and Timmermann (1995) examine the robustness of the evidence on the predictability of U.S. stock returns, and address the issue of whether this predictability could have been historically exploited by investors to earn profits in excess of a buy-and-hold strategy. Evidence of the predictability of stock market returns led the researchers to investigate the sources of this predictability. In Brock, Lakonishok and LeBaron (1992), two of the simplest and most popular trading rules, moving average and the trading range brake rules, are tested through the use of bootstrap techniques. They compare the returns conditional on buy (sell) signals from the actual Dow Jones Industrial Average Index to returns from simulated series generated from four popular null models. These null models are the random walk, the AR(1), the GARCH-M due to Engle, Lilien and Robins (1987), and the EGARCH developed by Nelson (1991). They find that returns obtained from buy (sell) signals are not likely to be generated by these four popular null models. They document that buy signals generate higher returns than sell signals and the returns following buy signals are less volatile than returns on sell signals. Brock, Lakonishok and LeBaron (1992) do not investigate the profitability of technical rules after realistic commissions, as they focused their attention to a bootstrapped-based view for specification testing. However, the results in Brock, Lakonishok and LeBaron (1992) document two important stylized facts. The first is that buy signals consistently generate higher returns than sell signals. The second is that the second moments of the distribution of the buy and sell signals behave quite differently because the returns following buy signals are less volatile than returns following sell signals. The asymmetric nature of the returns and the volatility of the Dow series over the periods of buy and sell signals suggest the existence of nonlinearities as the data generation mechanism. Gençay (1997a) investigates the nonlinear predictability of foreign exchange returns from the past buy sell signals of the simple technical trading rules by using the feedforward network and nearest neighbors regressions. The forecast results of Gençay (1997a) indicate that the buy sell signals of the moving average rules have market timing ability and provide statistically significant forecast improvements for the current returns over the random walk model of the foreign exchange returns. In Gençay (1997a), the optimal choice of nearest neighbors, optimal number of hidden units in a feedforward network and the optimal size of the training set are determined by the cross validation method which minimizes the mean square error. As the sample moves with the forecast horizon, the cross-validated performance is recalculated to obtain the optimal number of nearest neighbors, number of hidden units and the length of the training set. Therefore, the optimal number of nearest neighbors, number of hidden units and the length of the training data set may be different corresponding to each observation in the prediction sample. The type of the cross-validation method used in Gençay (1997a) allows the optimal number of nearest neighbors, optimal number of hidden units and the length of the training set to be chosen dynamically. This allows nonstationarity to enter into the nonlinear models in an automatic fashion. The results in Gençay (1997b) provide similar conclusions with the Dow Jones Industrial Index series. The contribution of this paper is to extend the analysis to models where the simple technical trading rules are used to maximize the total returns of an investment strategy. The profitability of an investment strategy is evaluated against a simple buy-and-hold strategy on the security and its distance from the ideal net profit. Sign predictions provide valuable information for market timing. One such test which provides information on market timing is the Henriksson and Merton (H&M) (Henriksson and Merton, 1981) test. In the H&M test, the number of forecasts has a hypergeometric
3 R. Gençay / Economics Letters 59 (1998) distribution under the null hypothesis of no market timing ability. The second test is by Pesaran and Timmermann (1992) which is based on the direction accuracy of the forecasts and hence may provide important information on the statistical significance of sign predictions. The Pesaran and Timmermann (P&T) (Pesaran and Timmermann, 1992) test is a Hausman-type test and its limiting distribution is N(0,1). These two sign prediction tests are reported in this paper. The data series includes the first trading day in 1963 of the Dow Jones Industrial Average (DJIA) Index to June 30, The data set is studied in five subsamples to study the sensitivity of our results to sample variation. The forecast horizon is chosen to be the last 250 observations of each subsample, approximately 1 year of daily observations. The nonparametric model which maximizes the investment strategy is designed by feedforward networks, a class of artificial neural networks. The results indicate that nonparametric models with technical strategies provide significant profits when tested against a simple buy-and-hold strategy. In addition, the sign predictions of these models are statistically significant and the Henriksson and Merton (1981) test rejects the null hypothesis of no 2 market timing ability for all data sets. The model is presented in section two and the empirical results are presented in section three. 2. Model The minimization of the sum of squared residuals may not be the most efficient criteria, given that the investors are ultimately trying to maximize profits rather than error minimization. This paper considers a simple technical trading strategy in which positive returns are executed as long positions and negative returns are executed as short positions. The total return of such a strategy is given by n R 5O yr T t51 t t (1) where rt5log( p t/p t21) is the return of the stock at time t, yt is a variable interpreted as the recommended position which takes either a value of 21 (for a sell signal) or 1 (for a buy signal) and n is the number of observations. Here, yt is modelled as a function of the past returns. To compare the performance of this simple technical trading strategy, the return on a simple buy-and-hold strategy (R B) R 5 log( p /p ) (2) B t1h t is used as the benchmark where h indicates the holding period. The estimation of yt is carried out by a feedforward network. As a model selection criteria, a cross-validation method similar to Gençay (1997a) is used to determine the number of hidden units and the length of the training sample. Many authors have investigated the universal approximation 2 Data-snooping biases refer to the biases in the statistical inference that result from using information from data to guide subsequent research with the same or related data. Lo and MacKinlay (1990) illustrate that the potential magnitude of biases can result from data-snooping. Due to the nonexperimental nature of economics, these biases may be unavoidable. As Campbell, Lo and MacKinlay (1997) point out, data-snooping biases should at least be considered as a potential explanation for model deviations.
4 252 R. Gençay / Economics Letters 59 (1998) properties of neural networks (Gallant and White, 1988, 1992; Cybenko, 1989; Funahashi, 1989; Hecht-Nielsen, 1989; Hornik, Stinchcombe and White, 1989, 1990). Using a wide variety of proof strategies, all have demonstrated that under general regularity conditions, a sufficiently complex single hidden layer feedforward network can approximate any member of a class of functions to any desired degree of accuracy where the complexity of a single hidden layer feedforward network is measured by the number of hidden units in the hidden layer. For an excellent survey of the feedforward and recurrent network models, the reader may refer to Kuan and White (1994). 3. Empirical results The last 250 observations of each subsample are reserved for the out-of-sample forecast comparisons. Out-of-sample forecasts are completely ex ante, using only information actually available. The results are presented in Table 1. The estimated total return is calculated by n1h11 Rˆ 5 O yr ˆ T t5n11 t t (3) where h is the out-of-sample horizon and yˆ t is the estimated recommended position for the tth observation. The data used in this paper is daily data so that the model in Eq. (3) generates either a buy or a sell signal for each day. At the end of each day, the positions are closed and a new position is opened the following day. The model allows for short selling. The sign predictions measure the percentage of times the estimated network output assigns the Table 1 Out-of-sample tests Tests Total return Net return Sign predictions Ideal profit ratio Sharpe ratio Pesaran and Timmermann Henriksson and Merton Buy and hold return Notes: The Total Return refers to the returns generated by the optimization based technical trading strategy over the 250 days of forecast sample before transaction fees are taken into account. The Net Return refers to the returns generated by the optimization based technical trading strategy over the 250 days of forecast sample after transaction fees are taken into account. The Buy and Hold Return is calculated by log( p t1h /p t) where h5250 is the holding period, pt and pt1h are prices of the security at time t and t1h, respectively. In the Henriksson and Merton (1981) (H&M) test, the number of forecasts has a hypergeometric distribution under the null hypothesis of no market timing ability. In the table above, the p-values of the H&M test are reported and are statistically significant if less than 5%. The Pesaran and Timmermann (1992) (P&T) test, which is a Hausman-type test, is designed to assess the performance of sign predictions. As the limiting distribution of this test is N(0,1), its one-sided critical values at the 1%, 5%, 10% levels are 2.33, and 1.282, respectively.
5 R. Gençay / Economics Letters 59 (1998) correct buy or sell decision in accord with the sign of the corresponding return of a given period. The Sharpe Ratio is simply the mean return of the trading strategy divided by its standard deviation m ˆR T ]]. (4) s ˆR T The higher the Sharpe ratio, the higher the return and the lower the volatility. We also use another measure called ideal profit. The ideal profit measures the returns of the trading system against a perfect predictor and is calculated by O n1h11 t5n11 yr ˆ t t n1h11 RI 5 ]]]]. (5) ur u t5n11 t According to Eq. (5), RI51 if the indicator variable yˆ t takes the correct trading position for all observations in the sample. If all trading positions are wrong, then the value of this measure is RI521. An RI50 value is considered as a benchmark to evaluate the performance of an investment strategy. Table 1 presents the return calculations from the technical trading strategy. The forecast sample of each subperiod consists of the last 250 days which is approximately one year of daily data. Therefore, the last year of each subsample is used for forecast calculations. The Total Return and the Net Return refer to the returns generated by the optimization based technical trading strategy before and after brokarage fees are taken into account, respectively. Discount brokerage houses charge as low as $30 for up to 1000 shares irregardless of the shares prices. Assuming that each share is worth $100 and shares per trade, the value of a typical transaction is assumed to be $ In this paper, we base the net return calculations on $30 per 1000 shares. The total transaction cost is calculated as 3 $600 per trade. This includes the transaction costs for opening and closing of the daily position. In the model, the positions are closed every day and a new trade takes place the following day. Therefore, the total transaction costs for 250 days is $ The Buy and Hold Return is calculated by log( p t1h /p t), where h5250 is the holding period, pt and pt1h are prices of the security at time t and t1h, respectively. The buy-and-hold returns are presented in the second panel. The buy-and-hold returns vary substantially across the six subperiods. The largest negative buy-and-hold return occurs at the period whereas the largest positive return occurs at the period. For the period, the technical trading strategy generates a net return of 35% whereas the buy-and-hold return for this period is 236%. In the period, the buy-and-hold return and the trading strategy returns are 213% and 16%, respectively. In the period the technical strategy generates 7% net return whereas the buy-and-hold return remains at 220%. The other subperiods exhibit similar results such that the technical trading returns dominate the buy-and-hold returns. For all subperiods, the sign predictions for the recommended positions range 57 61%. The Pesaran-Timmermann and Henriksson-Merton tests indicate that the sign predictions of the technical model have market timing value across all subsamples. For all of the subsamples, the Sharpe ratios are 3 For simplicity the total transaction cost is assumed to be 10 times of $30 for shares.
Profitability ratios: What is it?
Profitability ratios measure a company’s ability to generate earnings relative to sales, assets and equity. These ratios assess the ability of a company to generate earnings, profits and cash flows relative to relative to some metric, often the amount of money invested. They highlight how effectively the profitability of a company is being managed.
Common examples of profitability ratios include return on sales, return on investment, return on equity, return on capital employed (ROCE), cash return on capital invested (CROCI), gross profit margin and net profit margin. All of these ratios indicate how well a company is performing at generating profits or revenues relative to a certain metric.
Different profitability ratios provide different useful insights into the financial health and performance of a company. For example, gross profit and net profit ratios tell how well the company is managing its expenses. Return on capital employed (ROCE) tells how well the company is using capital employed to generate returns. Return on investment tells whether the company is generating enough profits for its shareholders.
For most of these ratios, a higher value is desirable. A higher value means that the company is doing well and it is good at generating profits, revenues and cash flows. Profitability ratios are of little value in isolation. They give meaningful information only when they are analyzed in comparison to competitors or compared to the ratios in previous periods. Therefore, trend analysis and industry analysis is required to draw meaningful conclusions about the profitability of a company.
Some background knowledge of the nature of business of a company is necessary when analyzing profitability ratios. For example sales of some businesses are seasonal and they experience seasonality in their operations. The retail industry is example of such businesses. The revenues of retail industry are usually very high in the fourth quarter due to Christmas. Therefore, it will not be useful to compare the profitability ratios of this quarter with the profitability ratios of earlier quarters. For meaningful conclusions, the profitability ratios of this quarter should be compared to the profitability ratios of similar quarters in the previous years.
Cash Return on Capital Invested (CROCI)
Cash return on capital invested ( CROCI) is metric that compares the cash generated by a company to its equity. It is also sometimes known as “cash return on cash invested”. It compares the cash earned with the money invested.
DuPont formula (also known as the DuPont analysis, DuPont Model, DuPont equation or the DuPont method) is a method for assessing a company’s return on equity (ROE) breaking its into three parts.
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Earnings Before Interest After Taxes (EBIAT)
Earnings Before Interest and After Taxes is used to measure the ability of a firm to generate income through various operations during a specific course of time.
Earnings Retention Ratio
Earning Retention Ratio is also called as Plowback Ratio. As per definition, Earning Retention Ratio or Plowback Ratio is the ratio that measures the amount of earnings retained after dividends have been paid out to the shareholders.
EBIT (Earnings Before Interest and Taxes)
EBIT (Earnings Before Interest and Taxes) is a measure of a entity’s profitability that excludes interest and income tax expenses.
EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) is an indicator of a company’s financial performance. It measures a company’s financial performance by computing earnings from core business operations, without including the effects of capital structure, tax rates and depreciation policies.
Short for Earnings before Interest, Taxes, Depreciation, Amortization, Rent and Management fees, EBITDARM refers to a financial performance measure which is used in comparison to more common measures like EBITDA in situations where the rent and management fees of a company represent a larger-than-normal percentage of operating costs.
EBT (Earnings Before Tax)
Earnings before taxes (EBT) can be defined as the money retained by a company before deducting the money due to be paid as taxes.
Effective Rate of Return
The effective rate of return is the rate of interest on an investment annually when compounding occurs more than once.
Gross Profit Margin
Gross profit margin (gross margin) is the ratio of gross profit (gross sales less cost of sales) to sales revenue. It is the percentage by which gross profits exceed production costs. Gross margins reveal how much a company earns taking into consideration the costs that it incurs for producing its products or services.
Net Interest Margin
The net Interest margin can be expressed as a performance metric that examines the success of a firm’s investment decisions as contrasted to its debt situations. A negative Net Interest Margin indicates that the firm was unable to make an optimal decision, as interest expenses were higher than the amount of returns produced by investments. Thus, in calculating the Net Interest Margin, financial stability is a constant concern.
Net Profit Margin
Net profit margin (or profit margin, net margin) is a ratio of profitability calculated as after-tax net income (net profits) divided by sales (revenue). Net profit margin is displayed as a percentage. It shows the amount of each sales dollar left over after all expenses have been paid.
NOPLAT (Net Operating Profit Less Adjusted Taxes)
NOPLAT is Net Operating Profit Less Adjusted Taxes. It is a measurement of profit which includes the costs and the tax benefits of debt financing. In other words, it can be said that NOPLAT is the earnings before interest and taxes after making the adjustments for taxes. It is a firm’s total operating profit where adjustments for taxes are made. It shows the profits that are generated from the core operations of a company after making the deductions of income taxes which are related to the company’s core operations. For the creation of DCF models or the discounted cash flow models, often NOPLAT is used.
OIBDA (operating income before depreciation and amortization) is a non Generally Accepted Accounting Principle related measurement of finance based performance utilized by entities to display profitability in continuing business related activities that does not take into consideration the effects of tax based structure and capitalization.
Operating Expense Ratio
Operating expense ratio can be explained as a way of quantifying the cost of operating a piece of property compared to the income brought in by that property.
Operating margin ( operating income margin, return on sales) is the ratio of operating income divided by net sales (revenue).
Overhead ratio is the comparison of operating expenses and the total income which is not related to the production of goods and service. The operating expenses of a company are the expenses incurred by the company on a daily basis. The operating expenses include maintenance of machinery, advertising expenses, depreciation of plant, furniture and various other expenses. These expenses when controlled can provide a company by maintaining the quality of the business. All companies want to minimise overhead expenses so that it helps them understand and manage the revenues of the company.
In managerial economics, profit analysis is a form of cost accounting used for elementary instruction and short run decisions. A profit analysis widens the use of info provided by breakeven analysis. An important part of profit analysis is the point where total revenues and total costs are equal. At this breakeven point, the company does not experience any income or any loss.
Relative return refers to the return achieved by an asset over a specific time period contrasted to a benchmark. The relative return is computed as the difference between the absolute return reached by the asset and the return reached by the benchmark.
Return On Assets (ROA)
Return on assets (ROA) is a financial ratio that shows the percentage of profit that a company earns in relation to its overall resources (total assets).Return on assets is a key profitability ratio which measures the amount of profit made by a company per dollar of its assets. It shows the company’s ability to generate profits before leverage, rather than by using leverage.
Return on Average Assets (ROAA)
Return on Average Assets (ROAA) can be defined as an indicator used to evaluate the profitability of the assets of a firm. Putting it simple, this return on average assets indicates what a company can do with what it possesses. Generally, it is used by companies, banks and other financial institutions as an appraisal for determining their performance.
Return on Average Capital Employed (ROACE)
The return on average capital employed (ROACE) is a ratio that reveals the profitability against the investments made in the company. The ROACE is different from the return on capital employed for it counts the average of the opening and closing capital for the specific period contrasting to only the capital figure at the end of a period.
Return on Average Equity (ROAE)
The return on average equity (ROAE) refers to the performance of a company over a financial year. This ratio is an adjusted version of the return of equity that measures the profitability of a company. The return on average equity, therefore, involves the denominator being computed as the summation of the equity value at the beginning and the closing of a year, divided by two.
Return On Capital Employed (ROCE)
Return on capital employed (ROCE) is a measure of the returns that a business is achieving from the capital employed, usually expressed in percentage terms. Capital employed equals a company’s Equity plus Non-current liabilities (or Total Assets − Current Liabilities), in other words all the long-term funds used by the company. ROCE indicates the efficiency and profitability of a company’s capital investments.
Return on Debt (ROD)
The return on debt (ROD) can be expressed as the quantification of a company’s performance or net income as allied to the amount of debt issued by the company. Putting it other way, the return on debt refers to the amount of profit generated for every dollar held by a company in debt.
Return On Equity (ROE)
Return on equity (ROE) is the amount of net income returned as a percentage of shareholders equity. It reveals how much profit a company earned in comparison to the total amount of shareholder equity found on the balance sheet.
Return On Invested Capital (ROIC)
ROIC is the capital which is return on investment in business is a high-tech way of examining a stock at return on investment that corrects for some specialties of Return on Assets and Return on Equity.
Return on Investment (ROI)
Return on investment (ROI) is performance measure used to evaluate the efficiency of investment. It compares the magnitude and timing of gains from investment directly to the magnitude and timing of investment costs. It is one of most commonly used approaches for evaluating the financial consequences of business investments, decisions, or actions.
Return on Net Assets (RONA)
The return on net assets (RONA) is a comparison of net income with the net assets. This is a metric of financial performance of a company that takes into account earnings of a company with regard to fixed assets and net working capital.
Return on Research Capital (RORC)
The return on research capital (RORC) is a calculation used to assess the revenue earned by a company as an outcome of expenditures made on research and development activities. The return on research capital is an element of productivity and growth, as research and development is one of the techniques employed by the companies to develop new products and services for sale. This metric is generally used in industries that depend largely on R&D like the pharmaceutical industry.
Return on Retained Earnings (RORE)
The return on retained earnings (RORE) is a calculation to reveal the extent to which the previous year profits were reinvested. The return on retained earnings is expressed as a percentage ratio. A higher return on retained earnings indicates that a company would be better off reinvesting the business. On the contrary, a lower return on retained earnings indicates that paying out dividends might prove to be in the company’s best interests.
Return on Revenue (ROR)
The return on revenue ( ROR) is a measure of profitability that compares net income of a company to its revenue. This is a financial tool used to measure the profitability performance of a company. Also called net profit margin.
Return On Sales (ROS)
Return on sales (ROS) is a ratio widely used to evaluate an entity’s operating performance. It is also known as ” operating profit margin” or ” operating margin“. ROS indicates how much profit an entity makes after paying for variable costs of production such as wages, raw materials, etc. (but before interest and tax). It is the return achieved from standard operations and does not include unique or one off transactions. ROS is usually expressed as a percentage of sales (revenue).
Revenue per Employee
Revenue per employee measures the amount of sales generated by one employee. This is a measure of performance of human resources of a company. It is an indicator of productivity of company’s personnel. It also indicates how efficiently a company is utilizing its human resources.
It is a concept which measures the value of risk involved in an investment’s return. It is of great importance because it enables the investors to make comparison between performance of a high risk, high risk investment return with less risky and lower investment returns. Risk adjusted return can apply to investment funds, portfolio and to individual securities.
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What are Profitability Ratios?
Profitability ratios are financial metrics used by analysts and investors to measure and evaluate the ability of a company to generate income (profit) relative to revenue, balance sheet assets IB Manual – Balance Sheet Assets Balance sheet assets are listed as accounts or items that are ordered by liquidity. Liquidity is the ease with which a firm can convert an asset into cash. The most liquid asset is cash (the first item on the balance sheet), followed by short-term deposits and accounts receivable. This guide covers all balance sheet assets, examples , operating costs, and shareholders’ equity Stockholders Equity Stockholders Equity (also known as Shareholders Equity) is an account on a company’s balance sheet that consists of share capital plus retained earnings. It also represents the residual value of assets minus liabilities. By rearranging the original accounting equation, we get Stockholders Equity = Assets – Liabilities during a specific period of time. They show how well a company utilizes its assets to produce profit and value to shareholders.
A higher ratio or value is commonly sought-after by most companies, as this usually means the business is performing well by generating revenues, profits, and cash flow. The ratios are most useful when they are analyzed in comparison to similar companies or compared to previous periods. The most commonly used profitability ratios are examined below.
What are the Different Types of Profitability Ratios?
There are various profitability ratios that are used by companies to provide useful insights into the financial well-being and performance of the business.
All of these ratios can be generalized into two categories, as follows:
A. Margin Ratios
Margin ratios represent the company’s ability to convert sales into profits at various degrees of measurement.
Examples are gross profit margin, operating profit margin Operating Margin Operating margin is equal to operating income divided by revenue. It is a profitability ratio measuring revenue after covering operating and non-operating expenses of a business. Also referred to as return on sales , net profit margin Net Profit Margin Net Profit Margin (also known as “Profit Margin” or “Net Profit Margin Ratio”) is a financial ratio used to calculate the percentage of profit a company produces from its total revenue. It measures the amount of net profit a company obtains per dollar of revenue gained. , cash flow margin, EBIT EBIT Guide EBIT stands for Earnings Before Interest and Taxes and is one of the last subtotals in the income statement before net income. EBIT is also sometimes referred to as operating income and is called this because it’s found by deducting all operating expenses (production and non-production costs) from sales revenue. , EBITDA EBITDA EBITDA or Earnings Before Interest, Tax, Depreciation, Amortization is a company’s profits before any of these net deductions are made. EBITDA focuses on the operating decisions of a business because it looks at the business’ profitability from core operations before the impact of capital structure. Formula, examples , EBITDAR, NOPAT NOPAT NOPAT stands for Net Operating Profit After Tax and represents a company’s theoretical income from operations. Examples, formula, how to calculate NOPAT. Simple form: Income from Operations x (1 – tax rate) or Long form: [Net Income + Tax + Interest Expense + any Non-Operating Gains/Losses] x (1 – tax rate) , operating expense ratio, and overhead ratio.
B. Return Ratios
Return ratios represent the company’s ability to generate returns to its shareholders.
Examples include return on assets, return on equity, cash return on assets, return on debt, return on retained earnings, return on revenue, risk-adjusted return, return on invested capital, and return on capital employed.
What are the Most Commonly Used Profitability Ratios and Their Significance?
Most companies refer to profitability ratios when analyzing business productivity, by comparing income to sales, assets, and equity.
Six of the most frequently used profitability ratios are:
#1 Gross Profit Margin
Gross profit margin Net Profit Margin Net Profit Margin (also known as “Profit Margin” or “Net Profit Margin Ratio”) is a financial ratio used to calculate the percentage of profit a company produces from its total revenue. It measures the amount of net profit a company obtains per dollar of revenue gained. – compares gross profit to sales revenue. This shows how much a business is earning, taking into account the needed costs to produce its goods and services. A high gross profit margin ratio reflects a higher efficiency of core operations, meaning it can still cover operating expenses, fixed costs, dividends, and depreciation, while also providing net earnings to the business. On the other hand, a low profit margin indicates a high cost of goods sold, which can be attributed to adverse purchasing policies, low selling prices, low sales, stiff market competition, or wrong sales promotion policies.
Learn more about these ratios in CFI’s financial analysis courses.
#2 EBITDA Margin
EBITDA EBITDA EBITDA or Earnings Before Interest, Tax, Depreciation, Amortization is a company’s profits before any of these net deductions are made. EBITDA focuses on the operating decisions of a business because it looks at the business’ profitability from core operations before the impact of capital structure. Formula, examples stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It represents the profitability of a company before taking into account non-operating items like interest and taxes, as well as non-cash items like depreciation and amortization. The benefit of analyzing a company’s EBITDA margin EBITDA Margin EBITDA margin = EBITDA / Revenue. It is a profitability ratio that measures earnings a company is generating before taxes, interest, depreciation, and amortization. This guide has examples and a downloadable template is that it is easy to compare it to other companies since it excludes expenses that may be volatile or somewhat discretionary. The downside of EBTIDA margin is that it can be very different from net profit and actual cash flow generation, which are better indicators of company performance. EBITDA is widely used in many valuation methods Valuation Methods When valuing a company as a going concern there are three main valuation methods used: DCF analysis, comparable companies, and precedent transactions. These methods of valuation are used in investment banking, equity research, private equity, corporate development, mergers & acquisitions, leveraged buyouts and finance .
#3 Operating Profit Margin
Operating profit margin Operating Margin Operating margin is equal to operating income divided by revenue. It is a profitability ratio measuring revenue after covering operating and non-operating expenses of a business. Also referred to as return on sales – looks at earnings as a percentage of sales before interest expense and income taxes are deduced. Companies with high operating profit margins are generally more well-equipped to pay for fixed costs and interest on obligations, have better chances to survive an economic slowdown, and are more capable of offering lower prices than their competitors that have a lower profit margin. Operating profit margin is frequently used to assess the strength of a company’s management since good management can substantially improve the profitability of a company by managing its operating costs.
#4 Net Profit Margin
Net profit margin Net Profit Margin Net Profit Margin (also known as “Profit Margin” or “Net Profit Margin Ratio”) is a financial ratio used to calculate the percentage of profit a company produces from its total revenue. It measures the amount of net profit a company obtains per dollar of revenue gained. is the bottom line. It looks at a company’s net income and divides it into total revenue. It provides the final picture of how profitable a company is after all expenses, including interest and taxes, have been taken into account. A reason to use the net profit margin as a measure of profitability is that it takes everything into account. A drawback of this metric is that it includes a lot of “noise” such as one-time expenses and gains, which makes it harder to compare a company’s performance with its competitors.
#5 Cash Flow Margin
Cash flow margin – expresses the relationship between cash flows from operating activities Operating Cash Flow Operating Cash Flow (OCF) is the amount of cash generated by the regular operating activities of a business in a specific time period. The operating cash flow formula is net income (form the bottom of the income statement), plus any non-cash items, plus adjustments for changes in working capital and sales generated by the business. It measures the ability of the company to convert sales into cash. The higher the percentage of cash flow, the more cash available from sales to pay for suppliers, dividends, utilities, and service debt, as well as to purchase capital assets. Negative cash flow, however, means that even if the business is generating sales or profits, it may still be losing money. In the instance of a company with inadequate cash flow, the company may opt to borrow funds or to raise money through investors in order to keep operations going.
Managing cash flow Cash Conversion Cycle The Cash Conversion Cycle (CCC) is a metric that shows the amount of time it takes a company to convert its investments in inventory to cash. The cash conversion cycle formula measures the amount of time, in days, it takes for a company to turn its resource inputs into cash. Formula is critical to a company’s success because always having adequate cash flow both minimizes expenses (e.g., avoid late payment fees and extra interest expense) and enables a company to take advantage of any extra profit or growth opportunities that may arise (e.g. the opportunity to purchase at a substantial discount the inventory of a competitor who goes out of business).
#6 Return on Assets
Return on assets (ROA) Return on Assets & ROA Formula ROA Formula. Return on Assets (ROA) is a type of return on investment (ROI) metric that measures the profitability of a business in relation to its total assets. This ratio indicates how well a company is performing by comparing the profit (net income) it’s generating to the capital it’s invested in assets. , as the name suggests, shows the percentage of net earnings relative to the company’s total assets. The ROA ratio specifically reveals how much after-tax profit a company generates for every one dollar of assets it holds. It also measures the asset intensity of a business. The lower the profit per dollar of assets, the more asset-intensive a company is considered to be. Highly asset-intensive companies require big investments to purchase machinery and equipment in order to generate income. Examples of industries that are typically very asset-intensive include telecommunications services, car manufacturers, and railroads. Examples of less asset-intensive companies are advertising agencies and software companies.
Learn more about these ratios in CFI’s financial analysis courses.
#7 Return on Equity
Return on equity (ROE) Return on Equity (ROE) Return on Equity (ROE) is a measure of a company’s profitability that takes a company’s annual return (net income) divided by the value of its total shareholders’ equity (i.e. 12%). ROE combines the income statement and the balance sheet as the net income or profit is compared to the shareholders’ equity. – expresses the percentage of net income relative to stockholders’ equity, or the rate of return on the money that equity investors have put into the business. The ROE ratio is one that is particularly watched by stock analysts and investors. A favorably high ROE ratio is often cited as a reason to purchase a company’s stock. Companies with a high return on equity are usually more capable of generating cash internally, and therefore less dependent on debt financing.
#8 Return on Invested Capital
Return on invested capital (ROIC) Return on Invested Capital Return on Invested Capital – ROIC – is a profitability or performance measure of the return earned by those who provide capital, namely, the firm’s bondholders and stockholders. A company’s ROIC is often compared to its WACC to determine whether the company is creating or destroying value. is a measure of return generated by all providers of capital, including both bondholders Bond Issuers There are different types of bond issuers. These bond issuers create bonds to borrow funds from bondholders, to be repaid at maturity. and shareholders Stockholders Equity Stockholders Equity (also known as Shareholders Equity) is an account on a company’s balance sheet that consists of share capital plus retained earnings. It also represents the residual value of assets minus liabilities. By rearranging the original accounting equation, we get Stockholders Equity = Assets – Liabilities . It is similar to the ROE ratio, but more all-encompassing in its scope since it includes returns generated from capital supplied by bondholders.
The simplified ROIC formula can be calculated as: EBIT x (1 – tax rate) / (value of debt + value of + equity). EBIT is used because it represents income generated before subtracting interest expenses, and therefore represents earnings that are available to all investors, not just to shareholders.
Video Explanation of Profitability Ratios and ROE
Below is a short video that explains how profitability ratios such as net profit margin are impacted by various levers in a company’s financial statements.
Financial Modeling (going beyond profitability ratios)
While profitability ratios are a great place to start when performing financial analysis, their main shortcoming is that none of them take the whole picture into account. A more comprehensive way to incorporate all the significant factors that impact a company’s financial health and profitability is to build a DCF model DCF Model Training Free Guide A DCF model is a specific type of financial model used to value a business. The model is simply a forecast of a company’s unlevered free cash flow that includes 3-5 years of historical results, a 5-year forecast, a terminal value, and that provides a Net Present Value (NPV) NPV Formula A guide to the NPV formula in Excel when performing financial analysis. It’s important to understand exactly how the NPV formula works in Excel and the math behind it. NPV = F / [ (1 + r)^n ] where, PV = Present Value, F = Future payment (cash flow), r = Discount rate, n = the number of periods in the future of the business.
In the screenshot below, you can see how many of the profitability ratios listed above (such as EBIT, NOPAT, and Cash Flow) are all factors of a DCF analysis. The goal of a financial analyst is to incorporate as much information and detail about the company as reasonably possible into the Excel model Excel & Financial Model Templates Download free financial model templates – CFI’s spreadsheet library includes a 3 statement financial model template, DCF model, debt schedule, depreciation schedule, capital expenditures, interest, budgets, expenses, forecasting, charts, graphs, timetables, valuation, comparable company analysis, more Excel templates .
To learn more, check out CFI’s financial modeling courses online!
Thank you for reading this guide to analyzing and calculating profitability ratios. CFI is the official global provider of the Financial Modeling and Valuation Analyst designation FMVA® Certification Join 350,600+ students who work for companies like Amazon, J.P. Morgan, and Ferrari and is on a mission to help you Advance Your Career. With that goal in mind, these additional CFI resources will help you become a world-class financial analyst:
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- How to value a private company Private Company Valuation 3 techniques for Private Company Valuation – learn how to value a business even if it’s private and with limited information. This guide provides examples including comparable company analysis, discounted cash flow analysis, and the first Chicago method. Learn how professionals value a business
- Financial modeling guide Free Financial Modeling Guide This financial modeling guide covers Excel tips and best practices on assumptions, drivers, forecasting, linking the three statements, DCF analysis, more
Increase your profitability
Every business can improve its profitability. Sometimes a single factor can significantly increase profitability, but for most businesses increasing profitability means implementing a number of small improvements gradually.
1. Four ways to increase business profitability
There are four key areas that can help drive profitability. These are reducing costs, increasing turnover, increasing productivity, and increasing efficiency.
You can also expand into new market sectors, or develop new products or services.
This guide explains how to assess your business’ profitability, deliver growth for your bottom line, and how to plan and manage change.
2. Manage your costs
Close management of your costs can drive your profitability. Most businesses can find some wastage to reduce, it’s important not to cut costs at the expense of the quality of your products and services.
Have you looked at your key cost areas?
Your key cost areas to consider are:
- Suppliers – are you getting the best deal from suppliers? Can you negotiate better terms or do you need to change supplier? Can you drive better deals by consolidating your supplier base? Can you buy on a ‘just in time’ basis to make more effective use of your working capital?
- Finance – do you need to review your finance facilities? – are they at the most competitive terms available? Are you using any loans and overdrafts effectively?
- Premises – have you examined whether you are getting the most out of your space? Are there more efficient ways to use your premises? Could you sublet some unused space?
- Production – have you assessed whether you can cut waste and lower the costs of your materials. Check whether you can adapt your production processes so they are more streamlined, using fewer working hours or resources to cut labour costs.
Uncover real costs
Using activity-based costing is an effective way to find the real cost of specific business activities. Activity-based costing shows you how much it costs you to carry out a specific business function by attributing proportions of all your costs – such as salaries, premises or raw materials – to specific activities.
The initial analysis may take a little time but using activity-based costing often shows up costs (and therefore potential efficiencies) that you would not normally uncover using more traditional costing methods.
3. Review your offer
Look carefully at what you offer, who you sell it to and at what price and see if you can make improvements.
It’s a good idea to review your pricing regularly. Changes in your marketplace may mean that you can raise your prices without risking sales. However, it’s wise to test any price rises before you make them permanent.
Find your best customers
It’s not just your price list that affects your profitability – the type of customers you’re selling to can also make a big difference.
Consider the Pareto principle (often known as the 80/20 rule) and how it could apply to your business. In simple terms, applying the Pareto principle suggests that around 80 per cent of your profit is gained from 20 per cent of your products or services. The same percentage of profit is often also gained from the same percentage of customers.
Focusing on your most profitable customers – even if it means letting the less profitable ones go – could boost your profitability, so long as it is handled carefully.
Can you sell more to your best customers?
You may also be able to sell more to your most profitable customers. Consider the following opportunities:
- up-selling – selling them premium products that make a greater contribution to your profit
- cross selling – analysing what they buy and offering complementary products
- diversifying – identifying a need and developing new products and services to meet them
4. Buy more effectively
One of the most obvious routes to increasing your profitability is to buy more effectively. It makes sense to review your supplier base regularly and see if you can buy the same raw materials more cheaply or efficiently. However, try to ensure that you maintain quality at the same time.
Get the best deal from your suppliers
Identifying your key areas of expenditure will show where you spend most money.
Once you know where your money is going, shop around. Try bargaining with your suppliers – ask if you can have price reductions or discounts for early payment.
Consider using your status as a valued customer to agree long-term contracts or realistic annual minimum spends with regular suppliers to obtain a better price. You could also buy as part of a consortium with other similar businesses. If you can’t strike a better deal, consider switching to other suppliers.
Review the number of suppliers you use. Buying from too many can be inefficient – it takes up more time and dilutes your buying power. However, avoid placing all your business with one or two suppliers – it could leave you very vulnerable if things go wrong.
Cut waste throughout the business
A review of common areas of waste could help you see how to reduce them, for example:
- Can you cut your power costs, e.g. is all equipment turned off when it’s not being used?
- Are you getting the best deals from your power suppliers?
- Are you paying for unused services e.g. unused phone lines or photocopiers?
Consider whether you’re getting the best from your property. Your premises are a large expense , so get the most from your investment or rental agreement:
- Can you use your space more effectively by rearranging it?
- Could you sublet unused areas?
- Could you negotiate a lower rental if you agree to a longer contract?
5. Concentrate your sales efforts
There are two key strategies for boosting profitability through sales; selling more to existing profitable customers and finding similar customers to sell to.
Work with your best customers
You should know who your best customers are, what they buy and when they buy it.
You can usually put your customers and the products or services they buy into one of four categories:
- high sales and high profit
- high sales and low profit
- low sales and high profit
- low sales and low profit
It makes sense to encourage customers that provide high sales and high profit. You can also significantly boost your profitability by nurturing customers that provide high profit on low sales.
If customers are providing low profit from high sales, you can maybe revise pricing to generate more revenue from them. If customers are generating both low sales and low profits, consider whether it’s worth your while continuing to do business with them.
Find new ‘best’ customers
Make a judgement on expanding your customer base by finding new customers who have a similar profile to your existing profitable customers.
If you are sure you have covered your existing market as much as you can, consider moving into new markets.
6. Expand your market
Moving into new market areas can transform a business and, handled correctly, can significantly increase your profitability. However, expanding into new markets can be risky – and mistakes can prove very expensive.
Do your research
Before you start, carefully research the potential opportunity. Can you tailor or adapt existing products or services for new markets? This can provide new revenue at minimal cost and is ideal for boosting profit. For example, if you manufacture tools for the garden market, are there any potential applications for the tools in the construction industry?
Do you understand who your potential new customers are, why, when and how they will buy the product or service and how much they will pay for it?
You can also use social media to do research and gain alternative insights, opinions and feedback from your customers.
Developing new products and services
If you’re developing a new product or service for a new market, it’s good to carefully consider its viability. Key questions include:
- Do you have the skills and expertise in-house or will you have to buy them in?
- Have you got the commitment and resources available to make the new project work?
- Can you minimise the risk?
- Can you be sure there’s a demand for the new product or service at a price you can make a profit on?
Team up and reduce the risk
Rather than going it alone, partnerships and joint ventures can provide you with increased security in establishing yourself successfully in a new or expanded market.
7. Boost productivity
All businesses can minimise wastage costs and still remain competitive.
Measure your operational efficiency on an ongoing basis. Put systems and processes in place that will enable you to get the most from your resources.
For example, you could regularly monitor how many employee hours it takes to perform specific tasks or provide services. If the time increases, it indicates inefficiency – the quicker you eliminate this, the more your profitability will benefit.
The commitment to managing productivity must come from the top to be successful. Communicate your productivity targets and measurements so staff feel they have something to aim at.
You can also consider introducing staff incentives to keep to targets – but define them carefully so quality is not adversely affected by increased speed of production.
Defining the key performance indicators (KPIs) that are most suitable for your business would give you clear targets to aim for. They should reflect your goals, be measurable and comparable and allow for corrective action to keep your targets on track.
Streamline your processes
Stepping back on a regular basis and questioning whether there are more efficient ways to reach your goals is no bad thing. For example, you may always produce a particular type of product at a specific time in the month. But would it ease your cashflow if you produced, shipped and invoiced it earlier, or later, in the month?
It’s useful to get an idea about how comparable businesses approach similar issues. This is known as benchmarking. Benchmarking can be on a basic, like-for-like level – such as comparing energy costs between similar businesses – or it can be more detailed, such as sharing data and analysing production and stockholding patterns with other businesses you trust.
The additional perspective that benchmarking offers can provide new ideas and momentum to make your business more efficient.
When benchmarking, it is a good idea to focus on similar areas to the key performance indicators (KPIs) you have already identified. Although there are no standard templates you can use to benchmark your business, you could take the following steps:
- Deciding on the areas of your business that you want to improve or compare to others. You could do this through research techniques, such as informal conversations with customers, employees, or suppliers, focus groups, or marketing research, quantitative research, surveys and questionnaires.
- Researching your business’ processes and functions thoroughly and calculate how you will measure potential improvement.
- Finding industries that have similar processes you want to introduce – if you want to bring in an integrated IT system, you should find other businesses that currently use these types of system.
- Locate the businesses that are profitable in the industries you are interested in benchmarking – you can do this by consulting customers, suppliers, or trade associations.
- Survey these companies for their measures and practices and identify business process alternatives. If a business is reluctant to provide this information, you may get it through trade associations or commercial market reports.
8. Checklist: improving the profitability of your business
Improving your business’ profitability can help you to reduce costs, increase turnover and productivity, and help you to plan for change and growth.
How you increase your business’ profitability will depend on a number of factors – such as the business sector you work in, the size of your business, or its operating costs. However, you could review these options:
- locating areas in your business that could be improved or made more efficient – e.g. general business processes or administration
- using key performance indicators (KPIs) to analyse your strengths and weaknesses – e.g. rising costs or falling sales
- assessing your general business costs – e.g. overheads, how discounted deals with loyal customers affect your profits, how productive your staff are
- reviewing your areas of business waste and reduce them – e.g. power supply costs
- regularly reviewing the pricing of your products
- testing the prices of any products you review before making the changes permanent
- improving your profitability through your best customers – use up-selling, cross selling and diversifying techniques to improve your profit margins
- identifying areas of expenditure and limit these by bargaining with your suppliers
- long-term deals with suppliers to negotiate a better price on products
- researching new opportunities in your business sector and identifying where you could expand the market
- put monitoring systems and processes in place – e.g. benchmarking
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