Financial statements measure operations in absolute terms, i.e. in dollars, rupees or reais, depending upon the currency of denomination
Absolute measures are difficult, if not impossible, to compare across companies, since bigger companies, all else held constant, should have bigger dollar profits and carry more debt
Ratios scale absolute values to each other, and allow for
Contribution & Gross Margins: The Costs of Production
Contribution margin measures the pure profits that you generate with every marginal unit you sell, since it nets out only the variable cost associated with producing that unit, giving many software companies close to 100% contribution margins
Gross margins are a close relative, providing a direct measure of marginal profitability and an indirect measure of how revenue increases flow into profits. To illustrate, Zoom, one of the few stocks that has seen its value increase during the crisis, reported a gross marin of 92% in 2019
Companies with high contribution and high gross margins have much more profit potential, other things remaining equal, than companies with low margins
Operating margins measure what is left after the other operating expenses of the company, which cannot be directly traced to individual unit sales, but are nevertheless necessary for its operations
To the extent that these other operating costs (like SG&A) are fixed (or more fixed) than the costs of production, the difference between gross and operating margins becomes a simple proxy for potential economies of scale.
Companies with high gross margins and low operating margins should see operating profits (and margins) improve much faster as they scale up than companies where operating and gross margins are similar
The EBITDA is a rough measure of operating cash flows, rough because it is before taxes and capital expenditures
Notwithstanding that, it remains a measure of the cash generating capacity of a company, prior to discretionary choices (on how much to reinvest and borrow) and is used by
Lenders to determine whether the company can afford to borrow money, since debt has to be paid before capital expenditures are made
Equity investors to decide whether the entire business is fairly valued, before it tries to expand its asset base
Companies with high EBITDA margins generate higher cash flows per dollar of revenues and should be able to borrow more than companies with lower EBITDA margins
Netting out taxes and interest expenses, and adding back income from cash and cross holdings, yields net margin, a measure of what equity investors get to keep out of every dollar of revenues
It is a mixed and noisy measure, reflecting a company's operating model, its tax liabilities and its financial leverage (since debt creates interest expenses and affects taxes), as well as non-operating assets
Companies with high net margins deliver more profits for equity investors, in the aggregate, but perhaps not a per share basis (if debt is the reason why net margins are lower than operating margins).
With accounting returns, profits are scaled to measures of investment in a project or business
Broadly speaking, there can be differences in how accounting returns are measured based upon
How profits are measured, i.e., to just equity investors (net income) or to both debt and equity investors and whether profits are before or after taxes. In most cases, it is accrual income that is the basis for returns
How investment is measured, i.e., investment made just by equity investors or by debt and equity investors. In most cases, accounting returns use the book value as the basis of investment measurement
With any measure of accounting return, you can get different values depending upon timing, i.e., start of the period, end of the period or average for invested capital
Consistency rule: A consistent measure of accounting return will measure both profits and investment to the same group (equity or capital)
Debt Ratios measure how much a company has borrowed, relative to overall capital or to earnings/cashflows
Debt can be scaled to overall capital or just to equity
Debt to Capital = Debt / (Debt + Equity): This is a measure of how much of the capital in a company comes from debt
Debt to Equity = Debt / Equity: This is a close variant of debt to capital, with debt stated as a percent of equity
Debt can also be measured relative to earnings / cashflows
Debt to EBITDA = Debt / EBITDA : This measures how much debt a company has relative to the cash it generates from operations, before taxes and capital expenditures