Measuring Efficiency

Efficiency refers to how well a company converts its resources into profits, manages its assets, and uses equity to generate earnings. Below are a few key ratios we can use to measure efficiency.

Profit Margin

Profit margin is another measure of a company’s efficiency and profitability. It represents how much money the company gets to keep after all of its expenses. For example, a company with a profit margin of 30% keeps 30 cents for every $1 in revenue.

The higher the profit margin the better as it indicates the company is more efficient as it can generate the same level of earnings at a lower cost. Additionally, high profit margins provide a sort of cushion against market downturns. For example, because of the significant costs involved in maintaining a fleet of aircraft, the average profit margin in the airline industry is very low (only 2.6% at the time of writing). So when revenue evaporated during Covid-19 these airlines lost billions of dollars. These low margins are why Warren Buffett has said he will likely never invest in the airline industry again.

In general, you should look for a profit margin above 20%. But again, every industry is different and it is important to compare profit margins between similar companies.

You should also consider the change in profit margin over time, as it can reveal whether earnings are growing because of increasing revenue or decreasing costs. When costs are cut, the profit margin, being the ratio of net income to revenue, will increase, and vice versa. It is great to see an increasing profit margin together with growing revenue as it indicates the company is both expanding and cutting costs.

On the other hand, if revenue is growing while profit margin is falling it means that costs are growing faster than revenue. Again, not all costs are bad. In this situation, you should find out what the company is spending money on. Is it something that supports the future growth of the business? If not, it could indicate that continued expansion of the business is unsustainable.

Gross Margin

One measure of the efficiency of a company is gross margin. Gross margin measures how much money the company earns simply by selling its product before any indirect costs are subtracted. If a company is young it may not actually generate any income as it spends heavily on R&D and marketing. In these cases, earnings are negative and the profit margin is meaningless. This is where the gross margin can be helpful.

As a reminder, gross profit is equal to sales minus the cost of goods sold (COGS), which includes things like labour and raw materials. If it is more expensive for a company to make and sell its product, the gross margin will be lower. For example, something like a pair of shoes may cost the business $30 to make in terms of material and wages. If they can sell those shoes for $100 they would have a gross margin of 70%.

The software industry has very high gross margins because it is very inexpensive to distribute its product after it is created (it only has to be developed once and is infinitely scalable). On the other hand, the auto industry has very low gross margins because of the significant amount of raw materials and labour involved in producing every single vehicle.

Cash Flow Margin

The cash flow margin is a profitability metric, like the profit margin. It represents how much cash the business generates for every $1 it makes in revenue.

Again, the advantage of this ratio over its accrual-based counterpart is that it is cash-based and only includes cash flows from the core operations.

Return on Equity (ROE)

Return on equity (ROE) is another way to measure the efficiency of a company.

Return on equity is important because it directly determines the company’s growth rate. It measures the company’s ability to generate a return and grow its shareholders’ equity, which in turn increases its stock price. For example, a company with a ROE of 30% generates $0.30 for every $1.00 in shareholders’ equity, and you can expect the company to grow by 30%.

Generally, an ROE above 20% is considered good.