Looking at a company's profitability is a very important step in understanding a company. Profitability is essentially why the company exists and is a key component while deciding to invest or to stay invested in a company. There are many metrics involved in calculating profitability, but for this test, I will look at Caterpillar Inc's (NYSE:CAT) Earnings and Earnings Growth, Profit Margins, Profitability Ratios and Cash Flows.
Through the above-mentioned four main metrics, 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 which has been the most profitable.
Earnings and Earnings Growth
1. Earnings = sales x profit margin
• 2010 - $42.588 billion x 6.3% = $2.68 billion
• 2011 - $60.138 billion x 8.2% = $4.93 billion
Caterpillars' Earnings increased from $2.68 billion in 2010 to $4.93 billion in 2011.
2. Earnings per share = net income / shares outstanding
• 2010 - $2.68 billion / 631.5 million = $4.28
• 2011 - $4.93 billion / 645 million = $7.64
Caterpillars' Earnings per share increased from $4.28 in 2010 to $7.64 in 2011.
3. Five-year historical look at earnings growth
• 2007 - $3.54 billion, .1% increase
• 2008 - $3.56 billion, .5% increase
• 2009 - $895 million, 74.9% decrease
• 2010 - $2.68 billion, 199% increase
• 2011 - $4.93 billion, 84% increase
In analyzing the growth of Caterpillar Inc over the past five years, I find the company has posted very strong sales growth in the past two years. Over the past five years, the company has averaged earnings growth of 41.7%.
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 - $42.588 billion - $31.281 billion = $11.307 billion
• 2011 - $60.138 billion - $44.404 billion = $15.734 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 - $11.307 billion / $42.588 billion = 26.54%
• 2011 - $15.734 / $60.138 billion = 26.16%
As the gross profit margin decreased, it implies that management was slightly less efficient in its manufacturing and distribution in the production process than the year previous. The gross margin fell from 26.54% to 26.16%. As the gross margin decreased, Caterpillar Inc does not pass this metric.
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 that are incurred from operating activities and include things such as office supplies and heat and power.
• 2010 - $3.960 billion
• 2011 - $7.148 billion
7. Operating Margin = operating income / total sales
Operating margin is a measure 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 - $3.960 billion / $42.588 billion = 9.3%
• 2011 - $7.148 billion / $60.138 billion = 11.9%
As Caterpillar's Operating Margin has increased, it leaves more cash for the company to pay for its fixed costs. As the operating margin increased, Caterpillar passes on this metric.
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 - $2.68 billion / $42.588 billion = 6.3%
• 2011 - $4.93 billion / $60.138 billion = 8.2%
As Caterpillars' net profit increased, it implies that the company is more profitable than it was a year ago. To pass, the net income must increase. Caterpillar 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 - $4.248 billion / $42.588 billion = 9.97%
• 2011 - $5.203 billion / $60.138 billion = 8.7%
As the SG&A % Sales decreased, it implies that management is spending more efficiently. To pass, the SG&A % Sales must decrease. Caterpillar 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 - $2.68 billion / $64.020 billion = 4.2%
• 2011 - $4.93 billion / $81.446 billion = 6.05%
As the ROA increased from 4.2% in 2010 to 6.05% in 2011, it implies that management is using its assets to generate earnings. Caterpillar 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 - $2.68 billion / $10.824 billion = 24.75%
• 2011 - $4.93 billion / $12.883 billion = 38.26%
As the ROE increased from 24.75% in 2010 to 38.26% in 2011, it reveals that the company is generating more profits from the money shareholders have invested. Caterpillar 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 - $5.009 billion - $2.586 billion = $2.423 billion
• 2011 - $7.010 billion - $3.924 billion = $3.086 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 Caterpillars' 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 - $5.009 billion / $42.588 billion = 11.76%
• 2011 - $7.010 billion / $60.138 billion = 11.66%
As the companies cash flow margin is positive, it does not have to borrow money or raise money to keep operating. Even though the number is positive the margin has slipped. To pass, the cash flow margin must be positive and growing. Caterpillar does not pass.
In analyzing Caterpillar's profitability, it is clear that the company is profitable. The company's Earnings and Earnings growth has been strong, with an average increase of 41.7% over the past five years. Even though the economic recession had a great impact on Caterpillar's earnings in 2009, the company has recovered nicely.
Caterpillar passed all aspects of the Profit margins segment, expect for the gross margin. In 2010 through to 2011, the gross margin fell slightly, indicating that it was less efficient in manufacturing and distribution. The company had healthy increases in Operating Margin, Net profit margin and a decrease in the SG&A % Sales -which are all positive indicators of profitability. Caterpillar received 3 passes out of 4 on the Profit margins segment of the analysis.
Caterpillar passed all aspects of the profitability ratio segment of the analysis. The company had healthy increases in its ROA and ROE. As both aspects of the analysis displayed positive growth, Caterpillar received 2 passes out of 2.
Caterpillar passed one of the two aspects of the cash flow summary. As the free cash margin declined slightly, it is something to keep an eye on, but because the margin fell less than 2%, it does not raise any concerns. As the company's Free Cash Flow displayed positive results, the company receives 1 pass out of 2.
In analyzing Caterpillar's profitability, it is clear that the company has been very profitable over the past few years. Most aspects of profitability are positive, so there are no red flags raised with these aspects of Caterpillars' profitability.
For more fundamental information on Caterpillar, see Caterpillar: Inside The Numbers.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in CAT over the next 72 hours.