Corporations and their shareholders
are determined to make profits from their business operations
and make a good return on their investment (ROI). In order
to make good profits, a firm needs to be run efficiently
and have sufficient cash flow to meet current liabilities
and short term debt (liquidity). You as a small scale
investor need to investigate the profitability of a company
in order to determine if it is both liquid and it is being
run efficiently. The way to do this is by calculating
the various profit margin ratios available. We look at
a few below:
i) Gross Profit Margin
The Gross Profit Margin illustrates
the profit a company makes after paying off its Cost of
Goods sold (cost of inventory). Gross Profit Margin illustrates
to us how efficient the management is in using its labour
and raw materials in the process of production. The formula
for Gross Profit Margin is:
For example, imagine a company with
Gross Sales for 2006 equalling $5 million. The cost of
goods sold amounts to $1.2 million. What is the Gross
Profit Margin?
Firms that have a high gross profit
margin are more liquid and thus have more cash flow to
spend on research & development expenses, marketing
or investing. Avoid investing in firms that have a declining
Gross Profit Margin over a time period, example over 5
years. Once you calculate the gross profit margin of a
firm, compare it with industry standards. For example,
it does not make sense to compare the profit margin of
a software company (typically 90%) with that of an airline
company (5%).
ii) Operating Profit Margin
The Operating Profit Margin will
illustrate to you how efficiently the managers of a firm
are using business operations to generate profit. This
ratio also shows the success rate of these managers. The
formula for Operating Profit Margin is:
For example, consider a firm that
has $2 million sales this year and an EBIT (Earnings before
Interest & Taxes) of $450,000. What is the Operating
Profit Margin?
The higher the Operating Profit Margin,
the better. This is because a higher Operating Profit
Margin shows the company can keep its costs under control
(successful cost accounting). A higher Operating Profit
Margin can also mean sales are increasing faster than
costs, and the firm is in a relatively liquid position.
The difference between Gross Profit
Margin and Operating Profit Margin is that the gross profit
margin accounts for only Cost of Goods sold, but the Operating
Profit Margin accounts for both Cost of Goods sold and
Administration/Selling expenses.
iii) Net Profit Margin
Net Profit Margin tells you exactly
how the managers and operations of a business are performing.
Net Profit Margin compares the net income of a firm with
total sales achieved. The formula for Net Profit Margin
is:
For example, consider a firm that
has an annual net income of $500,000 while the total sales
achieved during the year amount to $2,200,000. What's
the Net Profit Margin?
Once you calculate the net profit
margin of a firm, compare it with industry standards.
For example, typical software companies have a Gross Margin
of 90% (as mentioned above). However, the NET profit margin
is only 27%. That's a huge difference right there and
it tells us that the marketing/administration costs of
software companies is huge! However, this also tells us
that operating costs and cost of goods sold of software
companies is relatively low.
