Looking at a companies profitability is a very important step in understanding a company. Profitability is essentially why the company exists and is a key component in a reason for investing or to stay invested in a company. There are many metrics in calculating profitability, but in this test I will look at Cummins Incorporated (CMI) Earnings and Earnings Growth, Profit Margins, Profitability Ratios and Cash Flows. With these four main sections we will understand more about the company's profitability and if this summary is compared with other companies in the same sector, you will be able see who has been most profitable.
Earnings and Earnings Growth
1. Earnings = sales x profit margin
• 2010 - $13.226 billion x 7.9% = $1.04 billion
• 2011 - $18.048 billion x 10.2% = $1.84 billion
Cummins' Earnings increased from $1.04 billion in 2010 to $1.84 billion in 2011.
2. Earnings per share = net income / shares outstanding
• 2010 - $1.04 billion / 197.80 million = $5.25
• 2011 - $1.84 billion / 192.00 million = $9.58
Cummins' Earnings per share increased from $5.25 in 2010 to $9.58 in 2011.
3. Five year historical look at earnings growth
• 2007 - $739 million, 15% increase
• 2008 - $755 million, 2% increase
• 2009 - $428 million, 43% decrease
• 2010 - $1.04 billion, 140% increase
• 2011 - $1.84 billion, 77% increase
In analyzing the growth of Cummins Inc over the past 5 years, the company has had a very strong sales growth. Over the past 5 years the company has averaged an earnings growth of 55%.
4. Gross Profit = Total sales - cost of sales
When analyzing a company, gross profit is very important because it indicates how efficiently management uses labor and supplies in the production process. More specifically, it can be used to calculate gross profit margin.
• 2010 - $13.226 billion - $10.058 billion = $3.168 billion
• 2011 - $18.048 billion - $13.459 billion = $4.589 billion
5. Gross Profit Margin = Gross Income / Sales
The gross profit margin is a measurement of a company's manufacturing and distribution efficiency during the production process. The gross profit tells an investor the percentage of revenue / sales left after subtracting the cost of goods sold. A company that boasts a higher gross profit margin than its competitors and industry is more efficient. Investors tend to pay more for businesses that have higher efficiency ratings than their competitors, as these businesses should be able to make a decent profit as long as overhead costs are controlled (overhead refers to rent, utilities, etc.)
• 2010 - $3.168 billion / $13.226 billion = 23.95%
• 2011 - $4.589 billion / $18.048 billion = 25.42%
As the gross profit margin increased, it implies that management was more efficient in it's manufacturing and distribution in the production process than the year previous. The gross margin went from 23.95% to 25.42%. As the gross margin increased Cummins Inc passes.
6. Operating income = Total sales - operating expenses
The amount of profit realized from a businesses operations after taking out operating expenses - such as cost of goods sold (COGS) or wages - and depreciation. Operating income takes the gross income (revenue minus COGS) and subtracts other operating expenses and then removes depreciation. These operating expenses are costs which are incurred from operating activities and include things such as office supplies and heat and power.
• 2010 - $1.621 billion
• 2011 - $2.681 billion
7. Operating Margin = operating income / total sales
Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt.
If a company's margin is increasing, it is earning more per dollar of sales. The higher the margin, the better.
• 2010 - $1.621 billion / $13.226 billion = 12.25%
• 2011 - $2.681 billion / $18.048 billion = 14.85%
As Cummins Inc. Operating Margin increased it leaves more cash for the company to pay for its fixed costs. As the operating margin increased Cummins passes.
8. Net Profit Margin = Net income / total sales
A ratio of profitability calculated as net income divided by revenues, or net profits divided by sales. It measures how much out of every dollar of sales a company actually keeps in earnings.
Profit margin is very useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Profit margin is displayed as a percentage; a 20% profit margin, for example, means the company has a net income of $0.20 for each dollar of sales.
• 2010 - $1.040 billion / $13.226 billion = 7.9%
• 2011 - $1.848 billion / $18.048 billion = 10.2%
As Cummins' net profit increased it implies that the company is more profitable than it was a year ago. To pass the net income must increase. Cummins Inc. passes.
9. SG&A % Sales = SG&A / total sales
Reported on the income statement, it is the sum of all direct and indirect selling expenses and all general and administrative expenses of a company.
High SG&A expenses can be a serious problem for almost any business. Examining this figure as a percentage of sales or net income compared to other companies in the same industry can give some idea of whether management is spending efficiently or wasting valuable cash flow.
• 2010 - $1.487 billion / $13.226 billion = 11.24%
• 2011 - $1.837 billion / $18.048 billion = 10.17%
As the SG&A % Sales decreased it implies that management is spending more efficiently. To pass the SG&A % Sales must decrease. Cummins' passes.
10. ROA - Return on Assets = Net income / total assets
ROA is an indicator of how profitable a company is relative to its total assets. ROA gives an idea as to how efficient management is at using its assets to generate earnings. Calculated by dividing a company's net income by its total assets, ROA is displayed as a percentage. Sometimes this is referred to as "return on investment."
• 2010 - $1.487 billion / $11.668 billion = 12.74%
• 2011 - $1.837 billion / $12.119 billion = 15.15%
As the ROA increased from 12.74% in 2010 to 15.15% in 2011, it implies that management is using it's assets to generate earnings. Cummins' passes.
11. ROE - Return on Equity = Net income / shareholder's equity
The amount of net income returned as a percentage of shareholders equity. Return on equity measures a corporation's profitability by revealing how much profit a company generates with the money shareholders have invested.
• 2010 - $1.487 billion / $5.492 billion = 27.07%
• 2011 - $1.837 billion / $6.010 billion = 30.56%
As the ROE increased from 27.07% in 2010 to 30.56% in 2011, it reveals that the company is generating more profits from the money shareholders have invested. Cummins' passes.
12. Free Cash Flow = operating cash flow - capital expenditure
A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt.
It is important to note that negative free cash flow is not bad in itself. If free cash flow is negative, it could be a sign that a company is making large investments. If these investments earn a high return, the strategy has the potential to pay off in the long run.
• 2010 - $1.006 billion - $364 million = $642 million
• 2011 - $2.073 billion - $622 million = $1.451 billion
As the final number in free cash flow is growing and positive it is a pass. If the free cash flow is negative, it will require more research to find out if the company is making large investments. As Cummins' free cash flow is positive the company passes.
13. Cash flow margin = Cash flow from operating activities / total sales
The higher the percentage, the more cash available from sales.
If a company is generating a negative cash flow, which would show up as a negative number in the numerator in the cash flow margin equation, then even as it is generating sales revenue, it is losing money. The company will have to borrow money or raise money through investors in order to keep on operating.
• 2010 - $1.006 billion / $13.226 billion = 7.6%
• 2011 - $2.073 billion / $18.048 billion = 11.48%
As the companies cash flow margin is positive it does not have to borrow money or raise money to keep operating. As the number is positive Cummins' passes.
In analyzing Cummins Inc. profitability it is clear that the company is very profitable. The company's Earnings and Earnings growth is very strong with an average increase of 55% over the past 5 years. Even though the economic recession had a great impact on Cummins' sales in 2009 the company has recovered nicely.
Cummins Inc. passes all aspects of the Profit margins part of analysis. The company had healthy increases in the Gross Profit Margin, Operating Margin, Net profit margin and SG&A % Sales. Cummins Inc. received 4 passes out of 4 on the Profit margins part of analysis.
Cummins Inc. passed all aspects of the profitability ratio part of the analysis. The company had healthy increases in it's ROA and ROE. As both aspects of the analysis displayed positive growth, Cummins Inc. received 2 passes out of 2.
Cummins Inc. passed both aspects of the cash flow summary. As the free cash flow displayed positive results and the cash flow margin also displayed positive growth, the company is showing positive cash flow. 2 passes out of 2.
In analyzing Cummins Inc. profitability it is clear that the company has been very profitable over the past few years. As all aspects of profitability are positive, there are no red flags raised with these aspects of Cummins' profitability.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CMI over the next 72 hours.