Israel Furniture Profit and Loss Report for the Year 2000
(Amounts in NIS)
- Sales: 100,000
- Cost of sale: 80,000
- Gross profit: 20,000
- Selling, administrative and general expenses: 5,000
- Operating profit: 15,000
- Financing expenses: 2,000
- Profit before tax: 13,000
- Income tax: 3,000
- Net profit: 10,000
Profitability ratios
- Gross profit on sales = 0.2
- Operating profit to sales = 0.15
- Net profit on sales = 0.1
Purpose of the relationship:
Profitability ratios are designed to examine the company’s ability to generate profits from its sales.
Meaning of the relationship:
The ratios indicate that every shekel of sales yielded to “Israel Furniture”:
- Gross profit of 0.2 NIS (20 Agorat).
- Operating profit of NIS 0.15 (15 Agorat).
- Net profit of 0.1 NIS (10 Agorat).
Interpretation of the results:
Profitability ratios vary from industry to industry, but in general, it can be said that the higher these ratios are, the more money the company is squeezing out of its “lemon.”
In industries, the accepted profitability ratios are:
- Gross profit ratio – between 20% and 40% (in 2003 the average for listed industrial companies in Israel was 29%).
- Operating profit ratio – between 5% and 10% (in 2003 the average for listed industrial companies in Israel was 6.6%).
- Net profit ratio – between 2% and 5%.
It is important to note that when a company has losses instead of profits (net loss, operating loss, or even gross loss), its profitability ratios will be negative. That is, it loses on every shekel it sells.
The worst case scenario is when the gross profit to sales ratio is negative. This means that total sales are less than the direct costs involved in producing the products, even before indirect costs are taken into account. This negative result should, in most cases, turn on a “red light” regarding the company’s performance.
Net income per share
Ratio data:
In “Israel Furniture”: (1,000 shares were issued)
Net profit per share = 10 NIS
The purpose of the relationship:
The ratio examines the profit generated by each of the shares held by the owner.
In some financial statements (mainly in companies traded on the stock exchange), the net profit per share ratio appears on the bottom line of the “Summary of the Income Statement” and does not need to be calculated.
Meaning of the relationship:
The figure of net income per share helps investors decide whether to buy or sell a stock.
For example:
Two companies in the same industry (Company A and Company B) each earned a net profit of 10,000 NIS per year. Company A has 1,000 shares, and Company B has 5,000 shares.
In light of this:
Company A’s net profit per share is NIS 10 (10,000 divided by 1,000 shares).
Company B’s net profit per share – 2 NIS (10,000 divided by 5,000 shares).
If the stock market price of each share were 200 NIS, everyone would rush to buy the shares of Company A (and no one would buy the shares of Company B), because at the same price it is possible to obtain a higher profit from the share of Company A.
Note:
It is worth noting in this context that there is a popular index called “earnings multiple” that is designed to analyze the feasibility of buying a particular stock.
A profit multiplier is obtained by dividing two figures:
The earnings multiple (or for short: the multiple) theoretically calculates how many years it takes to return the investment in the stock (the price we paid for the stock), assuming that the annual profit will not change in the future. In quite a few companies, the assumption that the net profit will not change in the future is unrealistic. Microsoft or Intel, for example, grow every year at an incredible rate, and it is unlikely that their profit will suddenly remain constant. In companies where it is likely that the profit in the future will remain constant or change, one way or the other, at low rates, it is found that the multiple will range between 6 and 12, meaning that we will return the investment in the stock within 6-12 years. On the other hand, in companies that are growing rapidly, it is found that the multiple can reach 20, 30, and even 100. The reason why investors are willing to pay for the stock at such high multiples will be explained by the following example, which refers to a company that is growing at a rapid pace and whose annual profit is expected to grow by approximately 30% per year.
The company’s profit data is presented in the following table:
| year | Stock price | Annual earnings per share | Cumulative earnings per share | multiplier |
|---|---|---|---|---|
| 2004 Date of purchase of the stock | 42 ₪ | 1.00 ₪ | 1.00 ₪ | 42 |
| 2005 | 1.30 ₪ | 2.30 ₪ | ||
| 2006 | 1.69 ₪ | 3.99 ₪ | ||
| 2007 | 2.20 ₪ | 6.19 ₪ | ||
| 2008 | 2.85 ₪ | 9.04 ₪ | ||
| 2009 | 3.71 ₪ | 12.75 ₪ | ||
| 2010 | 4.83 ₪ | 17.58 ₪ | ||
| 2011 | 6.27 ₪ | 23.85 ₪ | ||
| 2012 | 8.16 ₪ | 32.01 ₪ | ||
| 2013 | 10.60 ₪ | 42.61 ₪ |
From the data in the table above (column 4, last row), we learn that if the annual profit increases by 30% each year, then an investor who purchased the stock in 2004 for NIS 42 will accumulate a profit of NIS 42.61 after 10 years, meaning he will recoup his investment within 10 years. When the investor purchased the stock, the multiplier was 42, but the profit did not stay the same, so it took the investor less than 42 years to recoup his investment.
If, starting in 2013, the company’s growth stops, meaning that the profit from this year onwards will not change, and the multiple for similar companies will be 10, then the share price in 2013 should be 100.60 NIS (10.6X 10 (multiplier)), or in other words, the share price (100.6 NIS) divided by the annual profit (10.6) will give the multiple (10).
The profit multiplier can also be calculated by dividing the following two figures:
* The market value of a company is obtained by multiplying the share price by the total number of shares.
