Looking at profitability is a very important step in understanding a company. Profitability is essentially why the company exists and a key component in deciding whether 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 Potash Corporation of Saskatchewan (POT) 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 - $6.539 billion x 27.61% = $1.806 billion
- 2011 - $8.715 billion x 35.35% = $3.081 billion
Potash Corp's earnings increased from $1.806 billion in 2010 to $3.081 billion in 2011, an increase of 70.59%.
2. Five-year historical look at earnings growth
- 2007 - $1.104 billion, 57.28% increase over 2006
- 2008 - $3.495 billion, 31.59% increase
- 2009 - $988 million, 350% decrease
- 2010 - $1.806 billion, 82.97% increase
- 2011 - $3.081 billion, 70.59% increase
In looking at Potash Corp.'s earnings over the past five years, you can see that the company's earnings were impacted by the financial crisis in 2008 into 2009. As stated in the company's 2009 annual report, "Potash Corp was challenged by the extent and duration of the global economic crisis and its impact on our business." Even though the financial crisis greatly impacted the company, Potash Corp. still reported a net income of $988 million. As quoted in the 2009 annual report "This past year reminded us all of the contrast between long term fundamentals and short-term uncertainties.
Since 2009 the net income for the company has increased by 311% but the company earnings are is still down by 11.85% compared to the earnings 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 Potash Corp's gross profits for the past two years:
- 2010 - $6.539 billion - $3.914 billion = $2.625 billion
- 2011 - $8.715 billion - $4.429 billion = $4.286 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 reviewing Potash Corp's gross margin over the past five years, the margin has been increasing over the past 3 years. The 5-year low for the gross margin was reported in 2009 with a margin of 25.80%. The 5-year high for the margin was in 2008 with a margin of 51.94%. The 2011 gross profit margin of 49.18% is above the 5-year average of 40.60%.
- 2007 - $1.881 billion / $5.234 billion = 35.94%
- 2008 - $4.907 billion / $9.447 billion = 51.94%
- 2009 - $1.026 billion / $3.977 billion = 25.80%
- 2010 - $2.625 billion / $6.539 billion = 40.14%
- 2011 - $4.286 billion / $8.715 billion = 49.18%
The increase in the gross margin implies that management was more efficient in its manufacturing and distribution during the production process in 2011 compared to the 5-year average.
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 - $2.304 billion
- 2011 - $3.922 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, Potash Corp's operating margin reveals the same pattern as the earnings and the gross margin. In 2008 when the demand for fertilizers were strong the company's operating margin was 49.06%. In 2009 when the price of fertilizers plummeted the operating margin was directly affected. Since 2009 the operating margin has recovered but is still not quite as strong as 2008.
- 2007 - $1.588 billion / $5.234 billion = 30.34%
- 2008 - $4.635 billion / $9.447 billion = 49.06%
- 2009 - $1,192 billion / $3.977 billion = 29.97%
- 2010 - $2.304 billion / $6.539 billion = 35.23%
- 2011 - $3.922 billion / $8.715 billion = 45.00%
The 2011 operating margin of 45.00% is above the 5 year average of 37.92%. This implies that there has been a higher increase in the percentage of total sales left over after paying for variable costs of production such as wages and raw materials compared to the 5 year average.
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 and the gross profit margin Potash Corp's net profit margin has a correlation between fertilizer prices and the net profit margin. The 2011 net profit margin of 35.35% is above the 5-year average of 29.17%.
- 2007 - $1.104 billion / $5.234 billion = 21.09%
- 2008 - $3.495 billion / $9.447 billion = 36.99%
- 2009 - $988 million / $3.977 billion = 24.84%
- 2010 - $1.806 billion / $6.539 billion = 27.61%
- 2011 - $3.081 billion / $8.715 billion = 35.35%
As the 2011 net profit margin of 35.35% is above the 5-year average of 29.17%, this implies that there has been an increase in the percentage of earnings that the company is able to keep compared to the company's 5-year average.
8. 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."
The 2011 ROA of Potash Corp. has not exceeded the 2008 ROA of 34.10% but has rebounded nicely from the 2009 low of 7.65%. The 2011 ROA of 18.95% is above the 5 year average of 16.74%.
- 2007 - $1.104 billion / $9.717 billion = 11.36%
- 2008 - $3.495 billion / $10.249 billion = 34.10%
- 2009 - $988 million / $12.922 billion = 7.65%
- 2010 - $1.806 billion / $15.619 billion = 11.56%
- 2011 - $3.081 billion / $16.257 billion = 18.95%
As the 2011 ROA of 18.95% is above the 5-year average of 16.74, this implies that management has been more efficient at using the company's assets to generate earnings compared to its 5-year average.
9. 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 - $1.104 billion / $6.019 billion = 18.94%
- 2008 - $3.495 billion / $4.589 billion = 76.16%
- 2009 - $988 million / $6.501 billion = 15.20%
- 2010 - $1.806 billion / $6.804 billion = 26.54%
- 2011 - $3.081 billion / $7.847 billion = 39.26%
Like the ROA Potash Corp's ROE has rebounded nicely from the 2009 recession. As the 2011 ROE has rebounded nicely, this reveals that the company is generating strong profits compared to shareholders' equity.
10. 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 with the exception of 2009, Potash Corp's free cash flow has remained positive.
- 2007 - $1.689 billion - $607 million = $1.082 billion
- 2008 - $3.013 billion - $1.245 billion = $1.768 billion
- 2009 - $924 million - $1.818 billion = $-894 million
- 2010 - $2.999 billion - $2.019 billion = $980 million
- 2011 - $3.485 billion - $2.248 billion = 1.237 billion
The latest number, on the plus side, indicates that Potash Corporation has enough cash to develop new products, make acquisitions, pay dividends and reduce debt.
11. 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.
As Potash Corp's cash flow margin is positive, it does not have to take the above measures to continue operating.
- 2007 - $1.689 billion / $5.234 million = 32.27%
- 2008 - $3.013 billion / $9.447 billion = 31.89%
- 2009 - $924 million / $3.977 billion = 23.23%
- 2010 - $2.999 billion / $6.539 billion = 45.86%
- 2011 - $3.485 billion / $8.715 billion = 40.00%
In analyzing Potash Corp's earnings growth over the past five years, you can see the effect the 2009 recession had on the company. Since 2009 the earnings for the company has increased by 311% but the company earnings are is still down by 11.85% compared to the earnings peak in 2008.
As illustrated above and using a 5-year time frame, the listed profit margins are showing a strong recovery since 2008. All of the profit margins are still down from 2008 but are rebounding nicely.
The ROA and ROE indicate similar results. Both the ROA and ROE indicate a strengthening in the profitability of the company but are still below 2008's peak.
With free cash flow and the free cash flow margin both displaying positive cash, Potash 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 Potash Corporations profitability tells the story of a very strong company that is recovering nicely from its 2009 lows. Over the past five years, the earnings as well as the other listed profitability margins and ratios have rebounded nicely from 2009. These trends show strong signals for the future as Potash Corporation has a large amount of free cash at hand, which means the company will likely continue to grow for the foreseeable future.
To read more fundamental analysis on Potash Corp. please read my article: Potash: Inside The Numbers
Disclosure: I am long POT.