[MUSIC] In this video, we will look at some of the common profitability ratios, like return on equity, return on asset, gross profit margin, operating profit margin, net profit margin, etc. We will continue to use Amazon's financial statements to compute these financial ratios. The first couple of profitability ratios measure how well the company has used its balance sheet resources to generate profit. These two ratios are Return of Equity, ROE, and Return on Assets, ROA. ROE is defined as the net income divided by the average shareholders' equity. The denominator is the average over two consecutive years. For 2015, we will average shareholder's equity from the 2014 and 2015 balance sheets. The reason we average over two consecutive years is that this number will change at least a few times in a year. So we won't know the exact level of shareholders' equity on each day during the year as profits are generated. In most cases, when we have one balance sheet item and one income statement item as a part of a ratio, we will use this method of averaging for the balance sheet item. To calculate Amazon's ROE for 2015, we know that its net income for 2015 is $0.60 billion. Its average shareholders' equity for 2015 is $12.06 billion. Dividing $0.60 billion by $12.06 billion, we get an ROE of 0.494 or 4.94%. For every dollar of shareholders' equity, Amazon earned a little less than $0.05 in profits. Similar calculations yield ROEs of negative 2.35%, 3.05% and negative 0.49%, respectively, for 2014, 13 and 12. This shows that Amazon's profitability has not been very stable over the last few years. And that it has been at its most profitable in 2015. The next profitability ratio is ROA. It is defined as a company's net income divided by its average total assets. Average total assets are defined much like average shareholders' equity for ROE. In 2015, Amazon's net income was $0.60 billion and its average total assets were $59.97 billion. Dividing the net income by the average total assets, Amazon's ROA for 2015 works out to be 0.99%. Every $1 in assets owned by Amazon in 2015 generated profits of less than $0.01. But similar to ROE, 2015 was the most profitable year for Amazon over the last four years. But its profitability changes quite dramatically every year. Now other types of profitability ratios are all based only on income statement items. This gives us an idea as to how well the company is managing its costs and hence maintaining its profitability. The first of these ratios is a gross profit margin, or gross margin. The gross margin is the ratio of the company's gross profit for the year divided by its revenues for the year. Gross profit is the difference between revenues and cost of goods sold, COGS. The gross margin tells us how well the company has managed its manufacturing costs or direct costs incurred in the delivery of its services. Companies would like the gross margin to be higher. In 2015, Amazon had revenues worth $107.01 billion and COGS worth $71.65 billion. Its gross profit was $35.36 billion, which when divided by its revenues and expressed as a percentage, use a gross margin of 33.04%. Comparing Amazon's gross margin over the last four years, you can see that is has consistently increased every year since 2012. You can add its variables and COGS, both have increased over the last four years. But revenues have increased at a faster rate than COGS, leading to an increase in gross margins over time. The next profitability ratio is the operating profit margin which is defined as the operating profit divided by revenue. Operating profit is also known as EBIT, earnings before interest and taxes. Amazon's EBIT in 2015 was $2.23 billion and its revenue was $107.01 billion. This gives us an operating profit margin of 2.09%, which is, again, the highest in the last four years. The fifth profitability ratio is the pretax margin, which is the earnings before taxes divided by revenues. Amazon's earnings before taxes in 2015 were $1.57 billion. Dividing this by its revenues of $107.01 billion gives the pretax margin to be 1.47%. Yet again, this is the highest in the last four years. The final profitability ratio we look at is the net profit margin or net margin. It is the net income divided by revenues. Amazon's net income in 2015 was $0.6 billion. Dividing this by revenues of $107.01 billion gives Amazon's net profit margin to be 0.56%, again, the highest in the last four years. Based on all the profitability ratios, it appears that Amazon is doing well in the most recent year compared to its recent past. Though its gross margin is 33.04%, its net margin is only 0.56%. Amazon's COGS is two-thirds of its revenues, whereas its other expenses account for almost all of the remaining one-third. To get a better sense of whether these ratios are too high or too low, Amazon's ratios should be compared to those of its competitors. In the next video, we will look at some of the more popular activity ratios. [MUSIC]
