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Looking at a company's profitability is a very important step in understanding the 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 3M Company's (NYSE:MMM) Earnings and Earnings Growth, Profit Margins, Profitability Ratios and Cash Flow.

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 - $26.662 billion x 15.32% = $4.085 billion
  • 2011 - $29.611 billion x 14.46% = $4.283 billion

3M's earnings increased from $4.085 billion in 2010 to $4.283 billion in 2011 or by 4.84%.

2. Earnings per share = net income / shares outstanding

  • 2010 - $4.085 billion / 725.50 million = $5.63
  • 2011 - $4.283 billion / 719.00 million = $5.96

3M Company's earnings per share increased from $5.63 in 2010 to $5.96 in 2011. This is an increase of 5.86%.

3. Five-year historical look at earnings growth

  • 2007 - $4.096 billion, 6.36% increase over 2006
  • 2008 - $3.460 billion, 18.38% decrease
  • 2009 - $3.193 billion, 8.36% decrease
  • 2010 - $4.085 billion, 27.93% increase
  • 2011 - $4.283 billion, 4.85% increase

In analyzing the earnings growth of 3M company over the past five years, you can see 3M has had a range of $3.193 billion in 2009 to $4.283 billion in 2011. The earnings have been increasing looking back to 2004 and over the past five years, the company has averaged earnings growth of 12.4%. Despite a year of significant natural disasters (Japan earthquake and Thailand flooding) and economic uncertainty in Europe, 3M company posted an earnings increase of 4.85% over 2010.

Profit Margins

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 - $26.662 billion - $13.831 billion = $12.831 billion
  • 2011 - $29.611 billion - $15.693 billion = $13.918 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 - $12.831 billion / $26.662 billion = 48.12%
  • 2011 - $13.918 billion / $29.611 billion = 47.00%

As the gross profit margin decreased, it implies that management was less efficient in its manufacturing and distribution in the production process than the year previous. The gross margin went from 48.12% to 47.00%.

As I noticed the margins getting tighter, I thought it necessary to look at previous gross margins to see if there was a pattern developing in the percentage of the margins.

  • 2007 - 47.93%
  • 2008 - 47.05%
  • 2009 - 47.63%

In looking at the gross margins for the past 5 years we see the 2011 gross margin of 47.00% was slightly below the 5-year average of 47.55%. As the margin is below the 5-year average this is something to watch for in the future.

6. Operating income = Total sales - operating expenses

The amount of profit realized from the operations of a business 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 - $5.918 billion
  • 2011 - $6.178 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 - $5.918 billion / $26.662 billion = 22.19%
  • 2011 - $6.178 billion / $29.611 billion = 20.86%

As 3M's Operating Margin has decreased, it leaves less cash for the company to pay for its fixed costs.

As I noticed the operating margins getting tighter, I thought it necessary to look at previous margins to see if there was a correlation between the earnings and the margin.

  • 2007 - 25.32%
  • 2008 - 20.65%
  • 2009 - 20.81%

In looking at the operating margin over the past 5 years, you can see that the 2011 margin is at the lower end of the 5-year average of 21.97%. Again this margin will be something to watch going forward.

8. Net Profit Margin = Net income / total sales

A ratio of profitability calculated as net income divided by revenue, 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 - $4.085 billion / $26.662 billion = 15.32%
  • 2011 - $4.283 billion / $29.611 billion = 14.46%

As 3M's net profit decreased, it implies that the company is less profitable than it was a year ago.

To get a greater picture of the net profit margin, I took a look at the past 5 years to see if I could find a trend.

  • 2007 - 16.74%
  • 2008 - 13.69%
  • 2009 - 13.80%

In looking at the net profit margin over the past 5 years, you can see that the 2011 margin at the upper end of the 5-year analysis. Even though it fell compared with 2010, it is still a good margin compared with the 5-year average of 14.78%

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 with other companies in the same industry can give some idea of whether management is spending efficiently or wasting valuable cash flow.

  • 2010 - $5.479 billion / $26.662 billion = 20.55%
  • 2011 - $6.170 billion / $29.611 billion = 20.83%

As the SG&A % Sales increased, it implies that management is spending less efficiently.

Profitability Ratios

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 - $4.085 billion / $30.156 billion = 13.54%
  • 2011 - $4.283 billion / $31.616 billion = 13.55%

As the ROA decreased from 13.54% in 2010 to 13.55% in 2011, it implies that management was slightly more efficient in using its assets to generate earnings.

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 - $4.085 billion / $15.663 billion = 26.08%
  • 2011 - $4.283 billion / $15.420 billion = 27.77%

As the ROE increased from 26.08% in 2010 to 27.77% in 2011, it reveals that the company is generating more profits from the money shareholders have invested.

Cash Flows

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 - $5.174 billion - $1.091 billion = $4.083 billion
  • 2011 - $5.284 billion - $1.379 billion = $3.905 billion

Even though the company's free cash flow has decreased by 4.5% it is not of concern as 3M still has 3.905 billion in free cash. As the number is positive it implies that 3M has enough cash to develop new products, make acquisitions, pay dividends and reduce debt.

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 - $5.174 billion / $26.662 billion = 19.41%
  • 2011 - $5.284 billion / $29.611 billion = 17.84%

As the company's cash flow margin is positive, it does not have to borrow money or raise money to keep operating. As the cash flow margin is positive, this suggests that it will not have to borrow or raise money to keep operating.

Summary

In analyzing the earnings growth of 3M over the past five years, you can see the company's earnings were down in 2008 and 2009 but the earnings have recovered nicely and are up by 4.57% over 2007's posted earnings of $4.096 billion.

As illustrated above, all of the listed profit margins have declined from 2010 to 2011. Even though all of the profit margins were weak in 2011, they were all in range of the 5 year margin averages. As all of the margins displayed a decrease in the past year this is one aspect of the company to watch going forward.

As the ROA and ROE were up, this implies that management was more efficient at using its assets to generate earnings than a year ago and the company generated more earnings with the money shareholders invested.

As the free cash flow and the free cash flow margin both display positive cash, this indicates that 3M company has enough cash to develop new products, make acquisitions, pay dividends and reduce debt without having to borrow or raise money to keep operating.

In analyzing 3M's profitability, it displays mixed results. The positives are: the company has recovered nicely from 2008 - 2009 and reported earnings 4.57% higher than 2007 compared with 2011. As well the company has positive profitability ratios (ROA, ROE) and positive cash flow implying that the company has money to pay its dividends and make acquisitions. The negative aspect of the analysis is: the declining profit margins. As all of the profit margins declined in 2011 this is an aspect of the company that should be closely watched. Based on the above analysis, 3M has displayed good earnings with mixed results in profitability.

For more fundamental analysis on 3M read my article: 3M Company: Inside The Numbers

Source: 3M: Profitability Analysis