Show Me the Money

The ability of a company to generate revenue and profits is fundamental for both the going concern perspective of the company as well as the returns to shareholders. It is these ratios that can give insight into the ability of the company to earn profits. These ratios give users a good understanding of how well the company utilized its resources in generating profit and shareholder value.

In the income statement, there are four basic ratios - gross profit, operating profit, pretax profit and net profit. The term "margin" can apply to the absolute number for a given profit level and/or the number as a percentage of net sales/revenues. Profit margin analysis uses the percentage calculation to provide a comprehensive measure of a company's profitability on a historical basis (3-5 years) and in comparison to peer companies and industry benchmarks. Basically, it is the amount of profit (at the gross, operating, pretax or net income level) generated by the company as a percent of the sales generated. The objective of margin analysis is to detect consistency or positive/negative trends in a company's earnings. Positive profit margin analysis translates into positive investment quality.

Formulas:

1. Gross Profit Margin = Gross Profit divided by Net Sales/Revenue
2. Operating Profit Margin = Operating Profit divided by NetSales/Revenue
3. Pretax Profit Margin = Pretax Profit divided by Net Sales/Revenue
4. Net Profit Margin = Net Income divided by Net Sales/Revenue

First, a few remarks about the mechanics of these ratios are in order. When it comes to finding the relevant numbers for margin analysis, the terms: "income", "profits" and "earnings" are used interchangeably in financial reporting. Also, the account captions for the various profit levels can vary, but generally are self-evident no matter what terminology is used.

Second, income statements in the multi-step format clearly identify the four profit levels. However, with the single-step format the financial statement users must calculate the gross profit and operating profit margin numbers.

To obtain the gross profit amount, simply subtract the cost of sales (cost of goods sold) from net sales/revenues. The operating profit amount is obtained by subtracting the sum of the company's operating expenses from the gross profit amount. Generally, operating expenses would include such account captions as selling, marketing and administrative, depreciation and amortization.

Third, FS users need to understand that the absolute numbers in the income statement don't tell us very much, which is why we must look to margin analysis to discern a company's true profitability. These ratios help us to keep score, as measured over time, of management's ability to manage costs and expenses and generate profits. The success, or lack thereof, of this important management function is what determines a company's profitability. A large growth in sales will do little for a company's earnings if costs and expenses grow disproportionately.

Let's look at each of the profit margin ratios individually:

Gross Profit Margin - A company's cost of sales, or cost of goods sold, represents the expense related to labor, raw materials and manufacturing overhead involved in its production process. This expense is deducted from the company's net sales/revenue, which results in a company's first level of profit, or gross profit. The gross profit margin is used to analyze how efficiently a company is using its raw materials, labor and manufacturing-related fixed assets to generate profits. A higher margin percentage is a favorable profit indicator.

Industry characteristics of raw material costs, particularly as these relate to the stability or lack thereof, have a major effect on a company's gross margin. Generally, management cannot exercise complete control over such costs. Companies without a production process (ex., retailers and service businesses) don't have a cost of sales exactly. In these instances, the expense is recorded as a "cost of merchandise" and a "cost of services", respectively. With this type of company, the gross profit margin does not carry the same weight as a producer-type company.

Operating Profit Margin - By subtracting selling, general and administrative (SG&A), or operating, expenses from a company's gross profit number, we get operating income. Management has much more control over operating expenses than its cost of sales outlays. Thus, users need to scrutinize the operating profit margin carefully. Positive and negative trends in this ratio are, for the most part, directly attributable to management decisions.

Pretax Profit Margin - Again many investment analysts prefer to use a pretax income number for reasons similar to those mentioned for operating income. In this case a company has access to a variety of tax-management techniques, which allow it to manipulate the timing and magnitude of its taxable income.

Net Profit Margin - Often referred to simply as a company's profit margin, the so-called bottom line is the most often mentioned when discussing a company's profitability. While undeniably an important number, investors can easily see from a complete profit margin analysis that there are several income and expense operating elements in an income statement that determine a net profit margin. It behooves investors to take a comprehensive look at a company's profit margins on a systematic basis.