Financial ratios can be a relatively easy way to assess various aspects of a company's performance. Spanning profitability, liquidity, efficiency, stability and valuation, many of these ratios are very common, and when the results of these ratios are compared to other companies in the sector, or on the same company over time, they can be a simple yet powerful tool in uncovering the underlying progress of the company against peers. This short series of tutorials will look at different types of ratios, applying them to a specific company and then showing how comparisons could be made against rival companies in order to assess relative attractiveness. This tutorial will look at five core profitability ratios.

Financial ratios are most useful when comparing like-for-like companies. For these profitability ratios we will therefore look at two companies that are very similar in terms of operation:

**British American Tobacco (LSE:BATS)**and

**Imperial Tobacco (LSE:IMT).**Both of these companies is involved in the production of tobacco-based goods, primarily cigarettes, and operate on a global scale. I will demonstrate how to calculate each of these ratios for British American Tobacco and then compare it with the figure for Imperial Tobacco. We will use the 2014 results for British American Tobacco, which can be found here.

Bear in mind that there may be certain adjustments that need to be made to some of the numbers we use to better reflect the operating performance of the companies, but for simplicity we will ignore these for now and just seek to apply the formulae.

**1. Return on Equity (ROE)**

ROE, measured as a percentage, tells an investor how much profit the company is making based on the funds that shareholders have injected into the company plus other 'equity'. The higher the percentage, the better.

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**British American Tobacco Calculation:**For this we need to identify the four components of the equation. For profit after tax we look at the income statement and extract it directly. For the remaining three components we need to look at the equity part of the balance sheet. The relevant figures and parts of the financial statements references can be found in the image to the right.

We can now compute the ratio:

**ROE =**(

**3393/5814) * 100% = 58.4%**

This compares to

**Imperial Tobacco's**ROE of 36.2%. Consequently, on this ratio British American Tobacco appears more attractive.

**2. Return on Capital Employed (ROCE)**

ROCE, measured as a percentage, tells an investor how much operating profit the company is making based on the total capital employed. The capital employed comprises all the cash invested into the company by shareholders and the profits made (Shareholder Equity), and cash injected via Non-Current Borrowings. The higher the percentage, the better.

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**British American Tobacco Calculation:**We already have the shareholder equity figure from the Return on Equity ratio: £5,814m. We still need to find the operating profit figure from the income statement and the non-current borrowings figure from the balance sheet. The relevant figures and parts of the financial statements references can be found in the image to the right.

We can now compute the ratio:

**ROCE = [ 4546/(9779+5814) ] * 100% = 29.2%**

This compares to

**Imperial Tobacco's**ROCE of 13.8%. British American Tobacco appears more attractive on this ratio too.

**3.**

**Return on Assets (ROA)**

ROA, measured as a percentage, tells an investor how much profit the company is making based on the assets it has purchased. Since the purpose of assets is to enable the creation of profit, the greater the return on assets and the higher the percentage, the better.

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**British American Tobacco Calculation:**We already have the profit after tax figure from the return on equity equation; it was £3,393m. So we need to find the Total Assets figure, and this can be found on the balance sheet. The relevant figures and parts of the financial statements references can be found in the image to the right.

We can now compute the ratio:

**ROA = (3393/26167) * 100% = 13.0%**

This compares to

**Imperial Tobacco's**ROA of 5.6%. Again British American Tobacco's return on assets is superior.

**4. Gross Profit Margin**

The gross profit margin tells you what proportion of revenues is translated into gross profit. In other words, it tells you what proportion of any particular unit sale is profit. If I can produce a book for 30p and I can sell it for 100p, then the gross profit is 70p and the gross profit margin is 70%. Generally speaking, the higher the gross profit margin the better as it suggests the company has a more defensible product hence it can charge a higher price.

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**British American Tobacco Calculation:**This is an easy calculation to make as the only two figures we need are on the income statement. However, British American Tobacco does not provide the line for Gross Profits in its income statement so we must quickly calculate it using the formula Revenues - Cost of Sales. Specifically for this sector, we will use the revenue post-duties since the tobacco sector is heavily taxed. The calculation and relevant figures and parts of the financial statements references can be found in the image to the right.

We can now compute the ratio:

**Gross Profit Margin = (10883/13971) * 100% = 77.9%**

This compares to

**Imperial Tobacco's**gross profit margin of 38.5%. This is significantly lower and is down to Imperial Tobacco also having a major European logistics division, which drags down the overall margin result. Excluding the logistics division, Imperial's gross margin is well north of 50%. British American Tobacco's overall gross margin is superior.

**5. Operating Profit Margin**

The operating profit margin tells you what proportion of revenues is translated into operating profit. The difference between this and gross profit is that operating profit takes into account indirect costs such as administrative expenses and depreciation. Measured as a percentage, the higher the better with a higher operating profit margin either suggesting that the company has a higher gross profit margin, or that it has a relatively low level of indirect costs.

**British American Tobacco Calculation:**The two figures we require are again able to be found on the income statement. We can use the revenue figure of £13,971m that we found for the gross profit margin calculation and we can also use the operating profit figure we found when calculating the ROCE; £4,546m.

We can now compute the ratio:

**Operating Profit Margin = (4546/13971) * 100% = 32.5%**

This compares to

**Imperial Tobacco's**operating profit margin of 15.1%. This was again depressed by the European logistics division that Imperial Tobacco has. British American Tobacco's overall operating profit margin is superior.

**Conclusion:**Whilst British American Tobacco has superior figures for all five of these profitability ratios, it's important to recognise that the two companies are not pure comparisons given Imperial's logistics division. This does make the margin calculations less useful. Nevertheless, what is clear is that the blended figures show British American Tobacco to generate superior returns given the assets/equity/liabilities it has used and the first three profitability ratios are useful in that respect.

But does that make British American Tobacco worth buying over Imperial Tobacco? No. We would need to check the relative valuations of each, the state of their balance sheets and concepts such as free cash flow.

**This tutorial has looked at five core profitability ratios that you can apply when conducting fundamental analysis, and can be applied to all cases where a company is profitable. It's a simple and relatively effective way to compare two similar companies.**