Looking at profitability is a very important step in understanding a company. Profitability is essentially why the company exists and a key component of deciding to invest or to remain invested in a company. There are many metrics involved in calculating profitability, but for this article, I will look at Eaton Corporation's (ETN) 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 by comparing this summary to 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 - $13.715 billion x 6.77% = $929 million
- 2011 - $16.049 billion x 8.41% = $1.350 billion
Eaton's earnings increased from $929 million in 2010 to $1.350 billion in 2011 or an increase of 68.81%.
2. Five-year historical look at earnings growth
- 2007 - $994 million, 4.63% increase over 2006
- 2008 - $1.058 billion, 6.43% increase
- 2009 - $383 million, 276% decrease
- 2010 - $929 million, 242% increase
- 2011 - $1.350 billion, 68.81% increase
In analyzing Eaton Corporation's earnings growth over the past five years, you can see that the company was hit especially hard due to the economic recession of 2008 - 2009. Having stated that, it is evident that the company has recovered nicely and is reporting earnings 35.81% higher than 2007 and 27.60% higher than its former peak in 2008.
3. Gross Profit = Total Sales - Cost of Sales
In 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. Here are Eaton Corporation's gross profits for the past two years:
- 2010 - $13.715 billion - $9.633 billion = $4.082 billion
- 2011 - $16.049 billion - $11.261 billion = $4.788 billion
4. 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.).
In analyzing Eaton Corporation's gross margin over the past five years, you can see a slight trend upward. The 2011 gross margin was the highest at 29.83%, while the lowest margin of 26.03% was reported in 2009. The 2011 gross profit margin is above the 5-year average of 28.17%.
- 2007 - $3.651 billion / $13.033 billion = 28.01%
- 2008 - $4.185 billion / $15.376 billion = 27.22%
- 2009 - $3.091 billion / $11.873 billion = 26.03%
- 2010 - $4.082 billion / $13.715 billion = 29.76%
- 2011 - $4.788 billion / $16.049 billion = 29.83%
The increase in the gross margin implies that management has been getting more efficient in their manufacturing and distribution during the production process.
5. 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, 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 - $1.036 billion
- 2011 - $1.553 billion
6. Operating Margin = Operating Income / Total Sales
Operating margin is a measure of the proportion of a company's revenue that 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.
Over the past five years, Eaton Corporation's operating margin has had a large dip ending in 2009 with a margin of 2.55%, then has been recovering back up to 9.68% in 2011. The 2011 operating margin of 9.68% is above the 5-year average of 7.24%.
- 2007 - $1.177 billion / $13.033 billion = 9.03%
- 2008 - $1.140 billion / $15.376 billion = 7.41%
- 2009 - $303 million / $11.873 billion = 2.55%
- 2010 - $1.036 billion / $13.715 billion = 7.55%
- 2011 - $1.553 billion / $16.049 billion = 9.68%
As the operating margin has been recovering over the past few years, this implies that there has been an increase in the percentage of total sales left over after paying for variable costs of production such as wages and raw materials.
7. 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.
Like the operating margin, Eaton Corporation's net profit margin also suffered a strong dip in 2009 with a reported net profit margin of 3.22%. Again like the operating margin, the net profit margin has recovered nicely with 2011 reporting a profit margin of 8.41%.
- 2007 - $994 million / $13.033 billion = 7.24%
- 2008 - $1.058 billion / $15.376 billion = 6.88%
- 2009 - $383 million / $11.873 billion = 3.22%
- 2010 - $929 million / $13.715 billion = 6.77%
- 2011 - $1.350 billion / $16.049 billion = 8.41%
As the net profit margin has been recovering over the past few years, this implies that there has been an increase in the percentage of earnings that the company is able to keep.
8. 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 provide insight as to whether management is spending efficiently or wasting valuable cash flow.
Eaton Corporation's SG&A as a percentage of sales has been relatively consistent over the past five years, with a high in 2009 at 18.97% and a low in 2008 at 16.34%. The 2011 rate is slightly below the 5-year average of 17.38%. This implies that management has been spending less of their percentage of total sales on the sum of all direct and indirect selling expenses during 2011 compared to the 5-year average:
- 2007 - $2.139 billion / $13.033 billion = 16.41%
- 2008 - $2.513 billion / $15.376 billion = 16.34%
- 2009 - $2.252 billion / $11.873 billion = 18.97%
- 2010 - $2.486 billion / $13.715 billion = 18.13%
- 2011 - $2.738 billion / $16.049 billion = 17.06%
9. 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."
Like many of its profitability margins, Eaton Corporation's ROA over the past five years shows a strong dip in 2009, then a nice recovery back up to and exceeding 2007 results.
- 2007 - $994 million / $13.430 billion = 7.40%
- 2008 - $1.058 billion / $16.655 billion = 6.35%
- 2009 - $383 million / $16.282 billion = 2.35%
- 2010 - $929 million / $17.252 billion = 5.38%
- 2011 - $1.350 billion / $17.873 billion = 7.55%
The current ROA of 7.55% is above the 5-year average of 5.80%. This implies that management has been more efficient at using the company's assets to generate earnings compared to its 5-year average.
10. ROE - Return on Equity = Net Income / Shareholders' Equity
As shareholders' equity is measured as a firm's total assets minus its total liabilities, ROE reveals the amount of net income returned as a percentage of shareholders' equity. The return on equity measures a company's profitability by revealing how much profit it generates with the amount shareholders have invested.
- 2007 - $994 million / $5.172 billion = 19.22%
- 2008 - $1.058 billion / $6.317 billion = 16.75%
- 2009 - $383 million / $6.777 billion = 5.65%
- 2010 - $929 million / $7.362 billion = 12.62%
- 2011 - $1.350 billion / $7.469 billion = 18.07%
Like many of the margins before, Eaton Corporation's ROE over the past five years shows a strong dip in 2009 then a nice recovery back up close to 2007 results. As the 2011 results are above the 2010 results, this reveals that the company is generating more profits compared to shareholders' equity.
11. 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.
Over the past five years, Eaton Corporation's free cash flow has been positive:
- 2007 - $1.158 billion - $354 million = $804 million
- 2008 - $1.441 billion - $448 million = $993 million
- 2009 - $1.408 billion - $195 million = $1.213 billion
- 2010 - $1.282 billion - $394 million = $888 million
- 2011 - $1.248 billion - $568 million = $680 million
The latest number, also on the plus side, indicates that Eaton Corporation has enough cash to develop new products, make acquisitions, pay dividends and reduce debt.
12. 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, it shows up as a negative number in the numerator in the cash flow margin equation. This means that even as the company 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.
Eaton Corporation's cash flow margin is positive, so it does not have to take these measures to continue operating:
- 2007 - $1.158 billion - $13.033 billion = 8.88%
- 2008 - $1.441 billion - $15.376 billion = 9.37%
- 2009 - $1.408 billion - $11.873 billion = 11.86%
- 2010 - $1.282 billion - $13.715 billion = 9.35%
- 2011 - $1.248 billion - $16.049 billion = 7.78%
In analyzing Eaton Corporation's earnings growth over the past five years, you can see that the company was hit especially hard by the economic recession of 2008 - 2009. Having stated that, it is evident that the company has recovered nicely and is reporting earnings 35.81% higher than 2007 and 27.60% higher than its former peak in 2008.
As illustrated above, many of the profit margins shown reveal a strong dip in 2009, and a nice recovery since then. In some cases, the recovery has exceeded previous highs, and in others, it has come close to previous highs.
Like the profitability margins, the ROA and ROE show similar results. The 5-year analysis shows a large dip in 2009 with a strong recovery for the next few years. The ROA has exceeded the 5-year previous high reported in 2007 while the ROE is slightly below the previous 5-year high.
With free cash flow and free cash flow margin both displaying positive cash, Eaton Corporation has enough cash to develop new products, make acquisitions, pay dividends and reduce debt without having to borrow or raise money to maintain operations.
The analysis of Eaton Corporation's profitability reveals a solid company that was hit hard by the economic recession and then looks to be recovering nicely.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.