[MUSIC] In this video, we will look at some of the common profitability ratios like return on equity, return on assets, gross profit margin, operating profit margin, net profit margin, etc. We will continue to use Amazon's financial statements to compute these financial ratios. The first couple of profitability ratios measure how well a company has used its balance sheet resources to generate profits. These two ratios, our return on equity, ROE, and return on assets, ROA. ROE is defined as the net income divided by the average shareholder's equity. The denominator is the average over two consecutive years. For 2015, we will average shareholders' equity from 2014 and 2015 balance sheets. The reason we average over two consecutive years is that this number will change at least a few times in a year. So we don't know the exact level of shareholders' equity on each day during the year as profits are generated. In most cases when we have one balanced sheet item and one income statement item as a part of a ratio, we will use this method of averaging for the balance sheet item. To calculate Amazon's ROE for 2015, we know that it's net income for 2015 was $0.60 billion. It's average shareholder's equity for 2015 was $12.06 billion. Dividing 0.60 billion by 12.6 billion, we get an ROE of 0.0494 or multiplying it by 100, we get 4.94%. For every dollar of shareholder's equity, Amazon earned a little less than $0.5 in profits. Similar calculations yield ROEs of negative 2.35%, positive 3.05% and negative 0.49% respectively for 2014, 13, and 12. This shows that Amazon's profitability has not been very stable over the last few years and that it has been at its most profitable in 2015. The next profitability ratio is ROA, it is defined as the company's net income divided by its average total assets. Average total assets are defined much like average shareholders equity for ROA. In 2015, Amazon's net income was $0.60 billion, and its average total assets was $59.97 billion. Dividing the net income by it's average total assets, Amazon's ROA for 2015 comes out to be 0.99%. For every $1 in total assets owned by Amazon 2015, it generated profits of less than 1 cent. But similar to ROA, 2015 was the most profitable year for Amazon over the last four years, but its probability changes quite dramatically every year. The other types of profitability ratios are all based on only income statement items. This gives us an idea as to how well the company is managing its cost and hence maintaining its profitability. The first these ratios, is the gross profit margin or simply gross margin. The gross margin is the ratio of the company's gross profit for the year divided by its revenues for the year. Gross profit is the difference between revenues and C-O-G-S, COGS. The gross margin tells us how well a company has managed its manufacturing cost or direct cost in current the delivery of its products or services. A company would like the gross margin to be hype. In 2015, Amazon had revenues worth $107.01 billion and COGS of $71.65 billion. Its gross profit was $35.36 billion, which when divided by its revenues and expressed as a percentage by multiplying it by 100 is a gross margin of 33.04%. Comparing Amazon's gross margin over the past four years you can see that it has consistently increase every year since 2012. Looking at its revenues and COGS both are increase over the last four years but revenues are increase faster rate than COGS leading to an increase in gross margins overtime. The next profitability ratio is the Operating Profit Margin, which is defined as the operating profit divided by revenue. Operating profit is also known as EBIT. Amazon's EBIT in 2015 was $2.23 Billion and it's revenue was $107.01 billion. This gives us an operating profit margin of 2.09% which is again the highest in the last four years. The fifth profitability ratio was the Pretax Margin, which is the earnings before taxes divided by revenue. Amazon's earnings before taxes in 2015 were $1.57 billion. Dividing these by its revenues of $107.01 billion gives the pretax margin to be 1.47%. Yet again this is the highest in the last four years. The final profitability ratio we look at is the Net Profit Margin or simply Net Margin. It is the net income divided by revenues. Amazon's net income in 2015 was $0.60 billion. Dividing this by its revenues of $107.01 billion gives Amazon's net profit margin to be 0.56%, again the highest in the last four years. Based on all profitability ratios it appears that Amazon is doing well in the most recent year compared to it's recent past. Though it's gross margin is 33.04%, it's net margin is only 0.56%. Amazon's COGS is two thirds of all its revenues, where it's other expenses account for almost all of the remaining one third. To get a better sense of whether these ratios are too high or low, Amazon's ratio should be compared to those of its competitors. I will let you try this on your own. In the next video we will look at some of the more popular activity ratios. [MUSIC]