This is the last article in our four-part series on how to measure profitability.

Parts one, two, and three can be found here:

How to Measure Profitability, Part 1 - An explanation of profitability.
How to Measure Profitability, Part 2 - defining profitability ratios
(coming soon) How to Measure Profitability, Part 3 - comparing the profitability of two similar companies.

Our overzealous financial analysis team 
decided to analyze Borders’ profitability after reviewing Borders’ liquidity levels while writing our How to Measure Liquidity article series.  Here is the results!

We didn’t intend to hassle Borders.  Our long-winded analysis, negative results, and gloomy outlook painted a perfect picture of a company pushed by the competition to the point they could not hold on any longer.

We reviewed Borders’ profitability just as we did in our Measure Profitability series, looking at a standard set of financial ratios selected for their ability to provide insight into company profitability.  We tried to go back a few years (2006-2009) to give a longer perspective of Borders’ performance, plus detailing each 2010 quarter for a more detailed view of how things developed.  We go through each ratio below, showing our ratio results in a table, accompanying graph, then giving our interpretation.

Let’s begin.

We started by first looking at Borders’ financial statements, pulling the following values out as we will be using these for the various ratios:

As you can see above, there is plenty of red. Operating profit, net earnings, and cash flow were all negative and gross profits were steadily declining.

Gross Profit Margin

The Gross Profit Margin ratio shows a steady decline in profitability, dropping by nearly half in the time span we measured.  Borders was clearly having trouble generating profits from its retail bookstores sales.  At least the gross profit margin is still positive, right?  Unfortunately, the next chart uncovers the mess…

Operating Profit Margin

In terms of the Operating Profit Margin ratio, Borders had zero operating profits early on, and swiftly plummeted into a steep operating loss.  Looking back in the Consolidated Statements of Operations, we find Borders’ operating profit is crushed under the weight of their Sales, General, and Administration expenses.  Borders’ efficiency in running their business was steadily declining and with a negative operating profit margin, they likely had to use their cash reserves to make up the difference.

Pretax Margin

Borders was not profitable before paying their taxes, and they certainly were not profitable after taxes. The Pretax Margin ratio was negative during the entire period.  The only positive result of negative profits is Borders’ taxes were much lower than if they had posted a positive operating profit margin.

Net Profit Margin

Borders did not have many other expenses other than taxes, so their net earnings was relatively the same as their earnings from operations, resulting in the Net Profit Margin ratio results shown above following the pretax margin ratio very closely.  After all bills and expenses have been paid, Borders is obviously not making any profits.

Cash Flow Margin

As the Cash Flow Margin ratio measures how well a company is generating cash from its operations, it is clear Borders is not.  Further, as the years passed, their losses continued to deepen, putting them in a more precarious financial position as time passed.  Looking at the numbers we used to calculate the cash flow margin, we see that as their net sales decreased, their cash flow from operations also decreased, but at an accelerated rate.  As Borders was experiencing less sales, they still had to pay for all the retail stores and the costs associated with their business, resulting in less cash available.

Cash Return on Assets

We get a hint they have problems converting their daily operations into cash from the cash flow margin above, but the results of the Cash Return on Assets ratio show better evidence that Borders’ investments in their assets are not providing a return on their money.  Looking back at the financial statements, we see their merchandise inventory and retail and warehouse property are significant but simply not providing a return.

Gross Profit to Net Sales

The Gross Profit to Net Sales ratio also shows problems with Borders’ ability to create profit from sales.  Steadily decreasing over Borders’ last four years, this ratio shows its inability to sell its products increasingly efficiently, which is what businesses need to accomplish to stay competitive.

Return on Equity (ROE)

How well has Borders made use of its available stockholder’s equity? The Return on Equity ratio results show that investments into the company made with equity have not realized any profit, and have in fact been negative.

There is an unusual spike in the third quarter of 2010, where the return on equity goes sharply positive.  However looking back at our original financial statement data, both net earnings and total stockholders equity are negative values.  Since we are simply dividing one by the other, a negative number divided by another negative number is positive.  This does not mean Borders’ return on equity instantly became positive.  Several papers have been written on this special case when financial ratios fail to represent a firm’s performance.  Research Economist Susanne Trimbath explains this problem:

“…Negative return on equity is meaningless as a measure of firm performance. Financial statements and analysts’ reports usually note the ratio resulting from negative equity as “not meaningful” and do not report a figure.”

“…although a negative return on equity is meaningless as an absolute measure of firm performance, one might consider that it could at least be used as a measure of relative firm performance. Unfortunately, this is not actually the case¹…”

What do we do in this situation? Can we even make sense of the return on equity values? To start, Borders’ total stockholders equity is a negative value.  Since their liabilities exceed their assets, Borders is essentially broke.  At this point you would hope they could possibly dig themselves out with their earnings, but this too is negative.  By late 2010, Borders owed more to creditors than they owned in assets and for each dollar they made from sales, they were losing more than one dollar, shown in the net profit margin ratio results we already calculated above.  At this point, Borders is stuck.  With no earnings and owing more than they own, the threat of a bankrupt Borders in 2010 was real.

Return on Total Assets (ROI)

The Return on Total Assets ratio shows Borders has not been able to utilize investments in their assets. The key cause of this plummeting ratio is the decline in net earnings while their asset levels remained high.

Final Summary

With dropping profitability, negative earnings, and owing more money to creditors than they have assets, it looks like bankruptcy and subsequent liquidation was inevitable for Borders.  As we set out to analyze the profitability of Borders, this turned into a discovery of how unprofitable Borders had become in the years leading to its bankruptcy.

Stepping away from the numbers and researching the book sales industry as a whole, you will find a great shift in demands from consumers.  With the rise of e-books, and books available on devices from competing book sellers (notably Amazon’s Kindle^© and Barnes and Noble’s Nook^©), competitors of Borders were able to sell books without having to keep the same level of assets a typical book seller needs.  Less physical books mean less inventory, warehouses, staff to manage it all.  This translates into reduced cost of goods sold, less administrative cost, and improved the overall efficiency of booksellers running their operations.  Borders had achieved the ability for customers to purchase and download books digitally in 2010, but was likely too late to turn things around.

(coming soon) Back to How to Measure Profitability, Part 3

References

U.S. Securities and Exchange Commission (SEC) website, retrieved on 01/28/2012:

1. Trimbath, Susanne; “Lemmings to the Sea: The Inappropriate Use of Financial Ratios in Econometric Models”, page 3. http://www.milkeninstitute.org/pdf/lemmings_wp2001_01.pdf

This is the second article in a four-part series on how to measure company profitability.  Parts one, three, and four can be found here:

How to Measure Profitability, Part 1 - An explanation of profitability.
How to Measure Profitability, Part 2 - Defining profitability ratios.
(coming soon) How to Measure Profitability, Part 3 - comparing profitability of two companies.
How to Measure Profitability, Part 4 - Border Group Inc profitability just before bankruptcy.

So, how do we measure profitability? This can be a foggy and opinionated area, with many sources giving varying interpretations of which financial values are used to compute a given performance ratio. Further, what defines company profits, costs, and expenses may change depending on the industry the company operates in. If a company is a large conglomerate operating in many different industries, then you have much more work to do.

We will give you what we consider to be useful profitability ratios that are a starting place no matter what industry a company operates, and briefly explain why these ratios belong in your profitability analysis.

Gross Profit Margin

The Gross Profit Margin is the ratio of
gross profit to net sales.  It measures how successful a company can control its costs, and how efficient they are able to generate profits from sales of its products or services.

Operating Profit Margin

Operating Profit Margin is the ratio of
operating profit to net sales.  This ratio measures company efficiency, showing how well a company can convert sales from its daily operations to profits.

Pretax Margin

The Pretax Margin combines net
earnings with company income tax then divides net sales.  This ratio gauges how well a company can generate pre-tax profits given its sales, and show it can maintain low levels of operational expenses while keep its sales level strong.

Net Profit Margin

The Net Profit Margin is the ratio of
net earnings to net sales.  Dealing only with net values, this ratio reveals profit levels after all expenses are paid, and all costs associated with sales are deducted.

Cash Flow Margin

The Cash Flow Margin is the ratio of cash flow from operations to net sales.  This ratio gauges how successful a company is at generating a positive cash flow given its current sales.

Cash Return on Assets

The Cash Return on Assets ratio is
the ratio of cash flow from operations to total assets.  This ratio show positive results when a company generates strong cash flow given its investment in company assets.  This can be a very industry-specific ratio.

Gross Profit to Net Sales

The Gross Profit to Net Sales ratio
subtracts the cost of goods sold from net sales, revealing the gross profit, then divides net sales from the result.  Although this calculation is the same as the Gross Profit Margin, the Gross Profit to Net Sales is meant to bring focus to the company’s ability to keep the costs of their sales low, showing how expenses can erode profits.

Return on Equity (ROE)

The Return on Equity ratio is the ratio
of net earnings to total stockholders equity.  This ratio measures how well  contributions from stockholders are generating earnings for the company.  Generating earnings for stockholders is a primary goal of many companies, and this ratio provides a clear look into the company’s ability to deliver on this goal.

Return on Total Assets (ROI)

The Return on Total Assets ratio is the
ratio of net earnings to total assets.  This ratio measures how well the company is reinvesting its earnings back into itself.

As you look at each ratio and its accompanying equation, you can see how each profitability ratio measures company profitability from a slightly different perspective.  Each of these ratios exposes just a small amount of information. Used together, they can reveal how profitable a company is really operating.

In the next part of this series, we look two companies selling computer chips using their financial statements as a test of our profitability ratios and attempt to summarize their profitability levels.

Proceed to (coming soon) How to Measure Profitability, Part 3, or
go back to How to Measure Profitability, Part 1