Ratios, Margins and EPS — Turning Statements into Judgments

Raw statements give you numbers; ratios give you judgments. Is a $200M profit impressive? You can’t say until you know what it took to earn it — $200M of profit on $1B of equity (20% return) is excellent; the same $200M on $10B of equity (2%) is feeble. Ratios scale every figure against the resources that produced it, turning incomparable companies into a fair fight. This lesson covers the ratios that actually matter: profitability, leverage, efficiency, and the per-share earnings number that headlines every results announcement.

Return on equity — the headline profitability ratio

Analogy. You hand a friend $1,000 to run a lemonade stand. At year-end they give you back your $1,000 plus $200 of profit. Your return on the money you put in was 20%. Return on equity (ROE) asks exactly this of a company: for every dollar shareholders have tied up, how many cents of profit did the company generate?

Definition.

$\text{ROE} = \frac{\text{Net Income}}{\text{Shareholders' Equity}}$

ROE measures how efficiently a company turns owners’ capital into profit. Warren Buffett has called it one of the best single gauges of business quality — a company that sustainably earns 20%+ on equity is compounding owner wealth fast.

Worked example. Net income $80M, equity $400M: ROE = 80 / 400 = 20%. Each dollar of equity produced 20 cents of annual profit. Reinvested, that compounds — which is why high, durable ROE is the hallmark of a great business.

The DuPont decomposition — ROE is three levers

A single ROE number hides how it was achieved. The DuPont decomposition splits ROE into three multiplicative drivers:

$\text{ROE} = \underbrace{\frac{\text{Net Income}}{\text{Revenue}}}_{\text{net margin}} \times \underbrace{\frac{\text{Revenue}}{\text{Assets}}}_{\text{asset turnover}} \times \underbrace{\frac{\text{Assets}}{\text{Equity}}}_{\text{equity multiplier}}$

• Net margin — profitability per sale (pricing power, cost control).
• Asset turnover — sales squeezed from each dollar of assets (efficiency).
• Equity multiplier — leverage; how many dollars of assets each dollar of equity supports.

Worked example. A company with 10% net margin, 1.2× asset turnover, and a 2.0× equity multiplier: ROE = 0.10 × 1.2 × 2.0 = 24%. Crucially, two firms can post the same 24% ROE for opposite reasons: a luxury brand on fat margins and low leverage, or a bank on thin margins and enormous leverage. DuPont tells you which.

Misconception. “Higher ROE is always better.” Dangerously not. Because ROE includes the equity multiplier, a company can juice its ROE simply by piling on debt — fewer dollars of equity in the denominator inflates the ratio while the business gets riskier, not better. A 30% ROE built on 5× leverage is fragile; a 20% ROE with little debt is sturdier. Always decompose before you admire.

ROA and ROIC — profitability without the leverage flattery

Return on assets (ROA) strips leverage out by measuring profit against all assets, however funded:

$\text{ROA} = \frac{\text{Net Income}}{\text{Total Assets}}$

Because the denominator is total assets (not just equity), ROA can’t be inflated by borrowing — it asks how well management uses the whole asset base. A company with high ROE but low ROA is leaning hard on leverage.

Return on invested capital (ROIC) is the connoisseur’s measure — profit (specifically after-tax operating profit) against all the capital actually invested in the business, debt and equity alike:

$\text{ROIC} = \frac{\text{After-tax Operating Profit (NOPAT)}}{\text{Invested Capital (debt + equity)}}$

ROIC is prized because it answers the deepest question: does the business earn more on its capital than that capital costs? A company whose ROIC sustainably exceeds its cost of capital is genuinely creating value; one whose ROIC sits below its cost of capital destroys value with every dollar it reinvests, no matter how fast revenue grows.

Worked example. A company has $120M of after-tax operating profit on $1,000M of invested capital → ROIC = 12%. If its cost of capital is 8%, every dollar reinvested earns a 4-point spread — value creation. If its cost of capital were 14%, the same 12% ROIC would destroy value despite looking respectable.

Leverage and coverage — can the company carry its debt?

Debt-to-equity measures how much the company borrows relative to owner capital:

$\text{Debt-to-Equity} = \frac{\text{Total Debt}}{\text{Shareholders' Equity}}$

A D/E of 0.5 means 50 cents of debt per dollar of equity (conservative); a D/E of 3 means heavy borrowing. Acceptable levels vary wildly by industry — utilities and banks run high, software runs low.

Interest coverage asks whether profits comfortably cover the interest bill:

$\text{Interest Coverage} = \frac{\text{EBIT}}{\text{Interest Expense}}$

A coverage of 8× means operating profit is eight times the interest due — very safe. A coverage near 1× means almost all operating profit is swallowed by interest, leaving no cushion; below 1× the company can’t cover its interest from operations at all — a flashing red light.

Worked example. EBIT $150M, interest $30M → coverage = 150 / 30 = 5×. Comfortable. If a downturn halved EBIT to $75M, coverage falls to 2.5× — still survivable. But a company with $40M EBIT and $35M interest (coverage 1.1×) has almost no margin for error; one bad quarter and it can’t pay its lenders.

Misconception. “Debt-to-equity alone tells you if a company is over-leveraged.” Not by itself — coverage matters more. A utility with a high D/E but rock-steady cash flows and 6× interest coverage is far safer than a cyclical manufacturer with a lower D/E but volatile earnings and 1.5× coverage. The question isn’t just “how much debt?” but “can the cash flows carry it through a bad year?”

Efficiency ratios — how hard the assets work

Efficiency (or activity) ratios measure how well a company converts its assets into sales and cash:

• Asset turnover = Revenue / Total Assets — sales generated per dollar of assets (already met in DuPont).
• Inventory turnover = COGS / Average Inventory — how many times a year inventory is sold and replaced. High turnover = goods move fast; low = goods languish.
• Days sales outstanding (DSO) = (Receivables / Revenue) × 365 — average days to collect from customers. Rising DSO means customers paying slower — a cash and quality warning.

Worked example. A retailer with $600M COGS and $100M average inventory turns inventory 6× a year (600/100) — roughly every two months. A competitor at 12× sells through in one month, freezing far less cash in stock. The faster turner needs less working capital to run the same sales — a structural advantage that flatters every other ratio downstream.

Earnings per share — profit, sliced per share

Definition. Earnings per share (EPS) divides net income by the number of shares, giving profit attributable to each share:

$\text{Basic EPS} = \frac{\text{Net Income} - \text{Preferred Dividends}}{\text{Weighted Average Shares Outstanding}}$

EPS is the number that headlines every earnings report and feeds the P/E ratio (next lesson). It lets you compare profitability per unit of ownership across companies of different sizes and track a company’s profit on a per-share basis over time.

Worked example. Net income $80M, 40M weighted-average shares: basic EPS = 80 / 40 = $2.00. If the company had instead issued 80M shares, the same $80M profit would be just $1.00 per share — same business, half the EPS. Share count matters as much as profit.

Basic vs diluted EPS — counting the shares that might exist

Diluted EPS is the more conservative figure: it assumes every instrument that could turn into shares — stock options, convertible bonds, warrants — actually does, swelling the share count and shrinking EPS. It answers “what would EPS be if everyone with a claim on future shares cashed in?”

Worked example. Net income $80M, 40M basic shares, plus 5M shares from outstanding options if exercised:

$\text{Diluted EPS} = \frac{80}{40 + 5} = \frac{80}{45} = \$1.78$

The gap between basic ($2.00) and diluted ($1.78) — about 11% — measures how much existing shareholders’ slice could be watered down. For companies that pay staff heavily in options (many tech firms), this dilution gap is large and easy to overlook; always read diluted EPS, the more honest number.

Misconception. “Rising EPS always means a growing, more profitable business.” Not necessarily. A company can lift EPS with zero profit growth simply by buying back shares — shrinking the denominator. EPS rose; the business didn’t. (You saw this in the stock-markets course; here’s where it bites valuation.) Conversely, issuing lots of new shares can depress EPS even as total profit climbs. Always check whether EPS moved because profit changed or because the share count did.

A mixed recap pulling from the whole lesson:

Key Takeaways