Series 65

AAA

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
comments powered by Disqus
Related Articles
  1. Why Did ETFs Become So Popular?
    Markets

    Why Did ETFs Become So Popular?

  2. Seasonal Factors Ready To Turn Positive
    Stock Analysis

    Seasonal Factors Ready To Turn Positive

  3. 3 Money Moves To Make Before A Career ...
    Credit & Loans

    3 Money Moves To Make Before A Career ...

  4. Top Financial Frights: Emergencies & ...
    Investing Basics

    Top Financial Frights: Emergencies & ...

  5. Find Short-Sale Listings
    Investing

    Find Short-Sale Listings

Trading Center