Profitability and efficiency ratios: gross/operating margin, ROE and ROIC
Calculate margins, return on equity and return on invested capital, and use the DuPont formula to see what really drives returns.
What you will learn
- How to calculate gross, operating and net margin and what each one tells you
- How to calculate return on equity (ROE) and break it down with the DuPont formula
- How to calculate return on invested capital (ROIC) and compare it with the cost of capital
- Why a high ROE can hide high debt
Explanation
Contribution margin for a single product is covered in the Business course. Here we measure the profitability of a whole listed company.
Margins
- Gross margin = gross profit ÷ revenue. It reflects pricing power and production costs. Software companies often have very high gross margins; retailers and car makers much lower ones.
- Operating margin (EBIT margin) = EBIT ÷ revenue. It includes all operating costs and shows how efficiently the whole business runs.
- Net margin = net income ÷ revenue. It is also influenced by debt (interest) and tax.
Compare margins with the company's own history and with direct competitors, not with companies in other industries. A stable or rising margin over several years is more informative than one high value.
Return on equity
ROE = net income ÷ shareholders' equity. It answers: how much profit does the company earn on the owners' book capital? Ideally use average equity of the start and end of the year; in this lesson we use year-end equity for simplicity.
The DuPont formula splits ROE into three drivers:
ROE = net margin × asset turnover × equity multiplier
- Asset turnover = revenue ÷ total assets (how much revenue each euro of assets produces).
- Equity multiplier = total assets ÷ equity (how much of the assets is financed with debt; higher means more leverage).
Two companies can have the same ROE for very different reasons: one through high margins, another through heavy borrowing.
Return on invested capital
ROIC measures the return on all capital invested in the business, from shareholders and lenders, so debt does not distort it.
- NOPAT (net operating profit after tax) = EBIT × (1 − tax rate).
- Invested capital (one common definition) = equity + financial debt − cash.
- ROIC = NOPAT ÷ invested capital.
The key comparison is ROIC versus the cost of capital, the return investors and lenders require for the risk they take. If ROIC is consistently higher, growth creates value; if it is lower, growth can destroy value even while profits rise. The cost of capital cannot be observed directly; analysts estimate it, and the estimate is uncertain. Lesson 9 returns to this idea.
Worked example
Hypothetical example: Nordlicht AG (lessons 3 and 4). Revenue €500m, gross profit €200m, EBIT €60m, net income €35m, total assets €500m, equity €200m, financial debt €180m (€30m short-term + €150m long-term), cash €40m, tax rate 30%. Pension provisions are excluded from debt for simplicity.
- Gross margin: €200m ÷ €500m = 40.0%.
- Operating margin: €60m ÷ €500m = 12.0%.
- Net margin: €35m ÷ €500m = 7.0%.
- ROE: €35m ÷ €200m = 17.5%.
- DuPont check: 7.0% × (€500m ÷ €500m = 1.0) × (€500m ÷ €200m = 2.5) = 17.5%. ✔
- NOPAT: €60m × (1 − 0.30) = €42m.
- Invested capital: €200m + €180m − €40m = €340m.
- ROIC: €42m ÷ €340m = 12.4% (rounded).
If we assume (hypothetically) a cost of capital of 8%, Nordlicht earns about 4.4 percentage points above it. A large part of its 17.5% ROE comes from the equity multiplier of 2.5, meaning debt.
Common mistake
Practice activity
Hypothetical, tax rate 25% for both. Company X: revenue €100m, EBIT €20m, net income €12m, equity €40m, debt €60m, cash €0. Company Y: revenue €100m, EBIT €15m, net income €10m, equity €80m, debt €0, cash €20m. Calculate ROE and ROIC for both. Which business is stronger operationally?
Show solution
X: ROE = €12m ÷ €40m = 30.0%. NOPAT = €20m × 0.75 = €15m. Invested capital = €40m + €60m − €0 = €100m. ROIC = 15.0%.
Y: ROE = €10m ÷ €80m = 12.5%. NOPAT = €15m × 0.75 = €11.25m. Invested capital = €80m + €0 − €20m = €60m. ROIC = 18.75%.
X has the higher ROE because of debt; Y earns more on the capital the business actually uses and carries no debt risk.
Limitations: invested capital definitions differ (leases, pensions, goodwill), so compare companies only with the same definition.
Key takeaways
- Gross, operating and net margins show where profit is created or lost.
- DuPont: ROE = net margin × asset turnover × equity multiplier.
- ROIC = NOPAT ÷ (equity + debt − cash) removes the effect of financing.
- Growth creates value only when ROIC exceeds the cost of capital.
Next step
Next, you will check whether a company's debt and liquidity are safe.
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