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.
That's why 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 how well a company generates and retains money.
Why Use Profit-Margin Ratios?
It's tempting to rely on net earnings alone to gauge profitability, but it doesn't always provide a clear picture of a company. Using it as the sole measure of profitability can be a bad idea.
Profit-margin ratios, on the other hand, can give investors deeper insight into management efficiency. But instead of measuring how much a company earns from assets, equity or invested capital, these ratios measure how much money a company squeezes from its total revenue or total sales.
Margins 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, don't.
For example, suppose that Company A had an annual net income of $749 million on sales of about $11.5 billion last year. Its biggest 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 every dollar of sales, while Company returned less than 5 cents.
Gross Profit Margin
The gross profit margin tells us how much 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. This is the formula:
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 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. The airline industry has a gross margin of about 5%, while the software industry has a gross margin of about 90%.
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. This is the calculation:
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 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.
Knowing operating profit also gives an investor an opportunity to do profit-margin comparisons between companies that do not issue a separate disclosure of their cost of goods sold figures.
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 administration and selling costs as well as materials and labor, it should be a much smaller figure than the gross margin.
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 the managers are running a business:
Net Profit Margins = Net Profits after Taxes/Sales
If a company generates after-tax earnings of $100,000 on $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.
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 their distinct cost structures. Compared to its bigger cousins, the discount airline industry spends proportionately more on finance, administration and marketing, and proportionately less on 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 the costs 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 hard times. 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.
The Bottom Line
Margin analysis is a great tool to understand the profitability of companies. It tells us how effective 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 is fed into them. Correct analysis also depends on a consideration of the company's industry and its position in the business cycle.
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. As with any ratio used on its own, margins tell us a lot, but not the whole story, about a company's prospects.