Profitability is one of the key aspects that business managers, investors and other stakeholders look into in order to assess whether a business is successful or not. A company that is profitable will be able to pay its liabilities as they fall due. Profitable companies are also capable of distributing dividends to investors.

For many, if a company is not making any profit in the long-term, it would be better to halt operations altogether. Naturally, investors will also avoid that company like a plague, since there is no chance that they will get a return on their investment. Even banks and financial institutions will not even think about lending money to a business that is not making any profit, for fear that it won’t be able to meet its payments as they fall due.

There are many ways to assess a company’s profitability; and there are many tools that are available to conduct profitability tests. One of them – and quite probably the most popular one – is by looking at the company’s profit margin, or the percentage of profit out of total sales or receipts of the company for a given period or operating cycle.

How to Conduct a Profit Margin Analysis

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In this article, you will learn several things about 1) the profit margin and 2) conducting profit margin analysis.

THE PROFIT MARGIN

The profit margin is one of the most commonly used and most reliable indicators of profitability of a company. Investors are particularly interested to see how the management of a company is able to generate revenue, manage its costs and expenses, and generate profits over time. It is essentially a reflection on how efficient the business is in using its resources in its operations.

The main financial statement that will be used in profit margin analysis is the income statement, an example of which is shown below. The amounts are in thousands of dollars.

Sales / Receipts700
Less: Sales discounts, returns and allowances-35
Net Sales665
Less: Cost of sales-355
Gross Profit345
Less: Operating costs and expenses-220
Operating Profit125
Less: Interest and Taxes38
Net Profit87

Sales or Receipts refer to the gross earnings or receipts of the business from the sale of its products and services.

Sales discounts are reductions in the price of a product or service, usually in exchange of early payment by the buyer or purchaser. These are presented as deductions from the gross sales.

Sales allowances are reductions in the price of a product or service, mainly due to problems with the product or the service. It could be a problem in the quality of the product, or delays in the delivery or shipment. These allowances are deductions of Gross Sales.

Sales returns are product items or merchandise physically returned or sent back to the seller by the buyer, due to various reasons, ranging from defects, delayed shipping, and errors in the product, as well as errors in the quantity of merchandise ordered and delivered. These are deducted from the Gross Sales.

Net sales is the total sales or revenue, less the sales allowances, discounts, or returns.

Cost of sales (also cost of goods sold, or cost of service) refers to the costs directly attributed to the products or services being sold, such as the purchase price from suppliers (in a retail or merchandising concern) and direct labor, direct or raw materials, and manufacturing overhead (in a manufacturing concern).

Gross profit or gross income (also gross margin) is the measurement of the profit made from the company’s cost of sales. This income is primarily used in activities that are aimed at revenue generation in the future, such as marketing, advertising, and research and development.

Operating costs and expenses (also Selling, General and Administrative costs or expenses) include all expenses of the company used in all its selling, general, and administrative activities.

  • Selling expenses refer to the costs directly and indirectly related to the sale of a product or service, such as costs of advertising, packaging, warehousing, salaries of salespeople, communication expenses of sales staff, rental fee of sales facility, and delivery or postal costs of bringing the products to customers.
  • General and administrative expenses refer to all other expenses that are not related to the sales activity of the business, such as the rent of administrative office, salaries of the company president and all non-sales personnel, and telephone costs used in the administrative office.

Operating profit or operating income (also operating margin) refers to the earnings of the company from operations, before the deduction of interest and applicable taxes, against its gross sales or receipts.

Interests and taxes or, more specifically ‘interest expense’ and ‘income tax expense’ are the regulatory and mandatory fees that are not related to operations. Interest, after all, is a finance cost, and taxes are imposed by the government, so the company is bound to pay it regardless of the results of its operations.

Net profit or net income (also net margin) is said to be the “bottom line” of the company. Not only does it exclude all operating costs and expenses, it also deducts the interest and taxes that the company has to pay with regards to its sales.

Most often used profit margins

There are three key profit margin percentages that analysts focus on when evaluating a company’s profitability. For purposes of discussion of the three, let us use the sample income statement shown above.

Gross Profit Margin

This is the percentage of the company’s gross profit or gross margin against its cost of sales. Its purpose is to evaluate the pricing of the products relative to the cost of sales.

Gross Profit Margin     =     Gross Profit / Gross Sales

Changes in gross profit can be caused by changes in sales prices, unit volume of products sold, the product mix, purchase price of inventory for sale, the amount or volume of direct materials used, the labor rates, and amount and usage of overhead.

The computed Gross Profit Margin is 49.3% (= 345,000 / 700,000). This means that for every $100,000 of sales, the company has a gross profit of $49,300.

Operating Profit Margin

Unlike the gross profit margin, the Operating Profit Margin also deducts the operating costs and expenses of the company, except interest expenses, income taxes, interest income, and any gain or loss on sale of capital assets. This is why it is also referred to as “earnings before interest and taxes” or EBIT.

Its purpose is to assess the impact of the selling, general, and administrative costs and expenses of the business, and how it figures in the ability of the company to earn from its operations.

Operating Profit Margin     =     Operating Profit / Gross Sales

The operating profit margin equaly 17.9% (= 125,000 / 700,000).

Net Profit Margin

This is the ratio of earnings left after all costs and expenses have been deducted from gross Sales or gross Receipts. It answers the question: how much, out of every dollar sales, is a company actually earning?

Net Profit Margin     =     Net Profit / Gross Sales

In the example above, the Net Profit Margin is 12.4% (= 87,000 / 700,000). It basically means that, for every $1.00 sold, the company is earning a profit of $0.124.

CONDUCTING PROFIT MARGIN ANALYSIS

Significance

Profit margin analysis is often performed in a single company over a period of time, say for 5 to 10 consecutive years, to see how the company is growing in terms of sales, costs and profit. Similarly, profit margin may also be performed to compare two or more companies within the same industry, in order to see which company is performing better.

Some also perform profit margin analysis where the profit margin of a company is compared to an industry standard, which is derived from collected industry statistics. This is to see whether the company remains competitive in the industry or not.

From the point of view of investors, it is easy to see why they would rely on profit margin analysis: they want to make sure that they are putting their money on companies that are sure to earn enough profits so they can have a return on their investments. However, from the point of view of management, there are many reasons why profit margin analysis is important.

  • Profit margin analysis serves as a guide in making pricing decisions.
  • Profit margin analysis enables management to identify weak areas, such as hemorrhaging costs and ineffective revenue generation activities.
  • Profit margin analysis between companies will help management to see where the competitor is doing things right and where it is doing things wrong.
  • Profit margin analysis will show whether the company is able to match or beat industry standards, giving it competitive advantage.

Management can also use profit margin analysis as a warning device. For example, if the profit margin is low or on a decline over a specific period, it could mean that the profitability of the company is not all that secure. This can be seen as a foretelling that it could decline even further until the company incurs a loss. Management will then have to take action before that happens.

Implications and limitations

For some, it would appear that the only figure that matters in profit margin analysis is the bottom line, or the final percentage or ratio that has been calculated. However, there are a lot of variables involved that must be considered, instead of focusing on just that single percentage.

For example, it is possible that a company is able to maintain a high profit margin for five consecutive years. In fact, the final profit ratio is even increasing as the years went by. However, if you look beyond that final figure, you will realize that the costs have also increased exponentially over the years, while increase in sales is gradual.

The profit margin has several implications, but all of them are tied to the quality of decisions that are made by management and how those decisions are implemented.

Gross profit margin

This margin is an indicator of the efficiency of the management in using labor, raw materials, and overhead in the production or manufacturing process.

Extended or continuous decline of the gross profit margin can be caused by the following:

  • Poor pricing decisions. It is possible that the company is pricing the products too low. The company will then look into adjusting its selling prices appropriately.
  • Mismanagement of labor costs and raw materials. The company often does not have full control of the trend of labor costs and the price of raw materials. If left unchecked, the labor costs and raw materials costs may continue to rise and eating up much of the gross income that the company is earning from its sales. This requires vigilance on the part of the company, for it to revisit its price-setting procedures every now and then to see if they can adjust the selling price accordingly.

Operating profit margin

This profit margin is an indicator of management’s success in its revenue generation activities and campaigns. Usually, profit margin analysis starts with getting the gross profit margin. If it is too low, it follows that the operating profit margin is also very low, since there is no way that the business will gain a sizable profit, not even if the business managed to keep its operating costs low.

Low operating profit margin could mean that:

  • Operating costs and expenses have increased while sales have decreased or remained the same.
  • Operating costs and expenses have remained the same, but sales have decreased.
  • Operating costs and expenses have decreased, but sales have also decreased by a greater amount.

If a company shows high operating margins, it could mean that:

  • The company has effective price controls. Even if the costs increase, management is able to adjust the selling prices accordingly.
  • The company is good at growing its sales while keeping its operating costs low or steady.

Movement of the operating profit margin will urge management to review its cost management procedures: identify the causes of inefficiency and fix them, and review its pricing policies if they have to be revised.

Net profit margin

Companies usually prefer to have high net profit margin or return on sales ratio, since this presents it to be a company that can cope very well in case of unexpected downturns in the industry or economy. Unlike the gross profit margin and the operating profit margin, the net profit margin takes into account the taxes as well as finance costs.

  • A higher net profit means a bigger “cushion” in case the business experiences a drop.
  • High net profit margin indicates correct pricing of products and services.
  • High net profit margin is also an indicator that management exercises good control of its costs and expenses.

Meanwhile, having a low net profit margin could be because:

  • Sales have increased but operating costs and expenses, as well as interests and taxes, have also increased much faster than revenue.
  • Sales decreased while costs, interests and taxes remained the same or increased.
  • Sales remained constant while costs, interests and taxes have greatly increased.

There is a general consensus that, if your business has a net profit margin that is 10% or higher, you are doing very well. However, there are a lot of factors at play here, such as the industry that the business belongs to, the structure of the business, and the current state of the economy.

It is also possible that the company has undergone circumstances that led to the increase of decrease of its profit margins. Some of the usual events that could bring about these movements include restructuring of debt or a redesign of the product mix or product line.

Taking industry norms into account, it would not be entirely correct to assume that, if the business registers higher profit margins, it is doing better than the rest of the industry. Meanwhile, if the industry is doing well, and it is just the company that is suffering from low margins, it is time for management to sit up, pay attention and take action. If the trend of your company’s profit margin is in line with that of the industry as a whole – meaning, both are going down or both are going up – it means that it is not just your business that is affected by certain changes or events in the industry.

When it comes to evaluating a company’s financial performance, profit margin analysis is certainly a very effective tool. However, be careful not to take everything at face value, drawing your conclusions just by looking at the final profit margin or profit percentage that you were able to calculate. You still have to look into the reasons for the increase or decrease in order to get a clearer, better, and more accurate picture of the business’ profitability and overall financial performance.

Profit margin analysis focuses solely on a company’s profitability and financial performance; it does not tell the whole story. There are other financial ratios and tools that you may use in order to assess other aspects of the company’s growth and competitiveness.

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