Quantitative Methods of Evaluating Businesses and Investments - The Income Statement: Key Ratios - Profit and Operating Margin

The following ratios are used to analyze and compare financial statements. We will discuss each in more detail below.

7.5: Profit Margin = Net income ÷ sales7.6: Operating Margin = Operating profit ÷ net sales7.7: Interest Coverage Ratio = EBIT ÷ annual debt interest payments7.8: Price-Earnings Ratio = Market value per share ÷ earnings per share7.9: Price-to-Book Ratio = Current closing price of stock ÷ book value per share.(Where book value = total assets - intangible assets and liabilities)

Formula 7.5: Profit Margin measures how much out of every dollar in sales a company actually keeps in earnings. Profit margin is very useful when comparing companies in similar industries. A higher profit margin, compared to other industry competitors, indicates a more profitable company that has better control over its costs. Profit margin is displayed as a percentage. A 20% profit margin, for example, means that the company has a net income of 20 cents for each dollar of sales.Example: ABC Manufacturing reports quarterly net income of $4.4 million on sales of $25 million.

Profit margin = $4,400,000 / $25,000,000 = .176 or 17.6%

Look Out!Looking at the earnings of a company often doesn\'t tell the entire story. Increased earnings are good, but an increase does not mean that the profit margin of a company is improving. For instance, if a company has costs that have increased at a greater rate than sales, it leads to a lower profit margin. This is an indication that costs need to be under better control.

Imagine a company has a net income of $15 million from sales of $100 million, giving it a profit margin of 15% ($15 million/$100 million). If in the next year net income rose to $20 million on sales of $200 million, its profit margin would fall to 10%. So while the company increased its net income, it has done so with diminishing profit margins.Formula 7.6: Operating Margin allows you to compare a company's efficiency, or quality of operations, to that of other companies. This ratio is essentially the same as Profit Margin, except only income from operations is considered. Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production, such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt.Example: XYZ Technology reports an annual operating profit of $89 million on net sales of $345 million. What is its operating margin?

Operating margin = $89,000,000 / $345,000,000 = .258 or 25.8%

Look Out!Operating margin gives analysts an idea of how much a company makes (before interest and taxes) on each dollar of sales. When looking at operating margin to determine the quality of a company, it is best to look at the change in operating margin over time and to compare the company's yearly or quarterly figures to those of its competitors. If a company's margin is increasing, it is earning more per dollar of sales. The higher the margin, the better.

The article, The Bottom Line On Margins takes a deeper look at a company's profitability and profit margin ratios.

The Income Statement: Key Ratios

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