Let's face it, a company's most important goal is to make money and keep it, which depends on liquidity and efficiency. Because these characteristics determine a company's ability to pay investors a dividend, profitability is reflected in share price. As such, investors should know how to analyze various facets of profitability, including how efficiently a company uses its resources and how much income it generates from operations. Calculating a company's profit margin is a great way to gain insight into these and other aspects of how well a company generates and retains money.

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Why Use Profit-Margin Ratios?

The bottom line is the first thing many investors look at to gauge a company's profitability. It's awfully tempting to rely on net earnings alone to gauge profitability, but it doesn't always provide a clear picture of the company, and using it as the sole measure of profitability can have big repercussions.

Profit-margin ratios, on the other hand, can give investors deeper insight into management efficiency. But instead of measuring how much managers earn from assets, equity or invested capital, these ratios measure how much money a company squeezes from its total revenue or total sales.

Margins, quite simply, are earnings expressed as a ratio, or a percentage of sales. A percentage allows investors to compare the profitability of different companies, while net earnings, which are presented as an absolute number, cannot.

For example, suppose that Company A had an annual net income of $749 million on sales of about $11.5 billion last year. Its major competitor, Company B, earned about $990 million for the year on sales of about $19.9 billion. Comparing Company B's net earnings of $990 million to Company A's $749 million shows that Company B earned more than Company A, but it doesn't tell you very much about profitability. If you look at the net profit margin, or the earnings generated from each dollar of sales, you'll see that Company A produced 6.5 cents on each dollar of sales, while Company returned less than 5 cents.

There are three key profit-margin ratios: gross profit margins, operating profit margins and net profit margins.

1. Gross Profit Margin
The gross profit margin tells us the profit a company makes on its cost of sales, or cost of goods sold. In other words, it indicates how efficiently management uses labor and supplies in the production process.



Gross Profit Margin = (Sales - Cost of Goods Sold)/Sales


Suppose that a company has $1 million in sales and the cost of its labor and materials amounts to $600,000. Its gross margin rate would be 40% ($1 million - $600,000/$1 million).

Companies with high gross margins will have a lot of money left over to spend on other business operations, such as research and development or marketing, so be on the lookout for downward trends in the gross margin rate over time. This is a telltale sign of future problems facing the bottom line. When labor and material costs increase rapidly, they are likely to lower gross profit margins - unless, of course, the company can pass these costs onto customers in the form of higher prices.

It's important to remember that gross profit margins can vary drastically from business to business and from industry to industry. For instance, the airline industry has a gross margin of about 5%, while the software industry has a gross margin of about 90%.

2. Operating Profit Margin
By comparing earnings before interest and taxes (EBIT) to sales, operating profit margins show how successful a company's management has been at generating income from the operation of the business:



Operating Profit Margin = EBIT/Sales
If EBIT amounted to $200,000 and sales equaled $1 million, the operating profit margin would be 20%.

This ratio is a rough measure of the operating leverage a company can achieve in the conduct of the operational part of its business. It indicates how much EBIT is generated per dollar of sales. High operating profits can mean the company has effective control of costs, or that sales are increasing faster than operating costs.

Operating profit also gives investors an opportunity to do profit-margin comparisons between companies that do not issue a separate disclosure of their cost of goods sold figures (which are needed to do gross margin analysis). Operating profit measures how much cash the business throws off, and some consider it a more reliable measure of profitability since it is harder to manipulate with accounting tricks than net earnings.

Naturally, because the operating profit margin accounts for not only costs of materials and labor, but also administration and selling costs, it should be a much smaller figure than the gross margin.

3. Net Profit Margin
Net profit margins are those generated from all phases of a business, including taxes. In other words, this ratio compares net income with sales. It comes as close as possible to summing-up in a single figure how effectively managers run the business:



Net Profit Margins = Net Profits after Taxes/Sales

If a company generates after-tax earnings of $100,000 on its $1 million of sales, then its net margin amounts to 10%.

To be comparable from company to company and from year to year, net profits after tax must be shown before minority interests have been deducted and equity income added. Not all companies have these items. In addition, investment income, which is wholly dependent upon the whims of management, can change dramatically from year to year.

Again, just like gross and operating profit margins, net margins vary between industries. By comparing a company's gross and net margins, we can get a good sense of its non-production and non-direct costs like administration, finance and marketing costs.

For example, the international airline industry has a gross margin of just 5%. Its net margin is just a tad lower, at about 4%. On the other hand, discount airline companies have much higher gross and net margin numbers. These differences provide some insight into these industries' distinct cost structures: compared to its bigger, international cousins, the discount airline industry spends proportionately more on things like finance, administration and marketing, and proportionately less on items such as fuel and flight crew salaries.

In the software business, gross margins are very high, while net profit margins are considerably lower. This shows that marketing and administration costs in this industry are very high, while cost of sales and operating costs are relatively low.

When a company has a high profit margin, it usually means that it also has one or more advantages over its competition. Companies with high net profit margins have a bigger cushion to protect themselves during the hard times. Companies with low profit margins can get wiped out in a downturn. And companies with profit margins reflecting a competitive advantage are able to improve their market share during the hard times - leaving them even better positioned when things improve again.

The Bottom Line
Margin analysis is a great way to understand the profitability of companies. It tells us how effectively management can wring profits from sales, and how much room a company has to withstand a downturn, fend off competition and make mistakes. But, like all ratios, margin ratios never offer perfect information. They are only as good as the timeliness and accuracy of the financial data that gets fed into them, and analyzing them also depends on a consideration of the company's industry and its position in the business cycle.

Remember, margin ratios highlight companies that are worth further examination. Knowing that a company has a gross margin of 25% or a net profit margin of 5% tells us very little without further information. As with any ratio used on its own, margins tell us a lot, but not the whole story, about a company's prospects.

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