Analysis of Company Profit Margin (Gross, Operating & Net Profit Margin)

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: Gross Profit Margin = (Sales - Cost of Goods Sold) / Sales 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? Gross Profit Margin = (5,000,000 - 1,200,000) / 5,000,000 Gross Profit Margin = 3,800,000 / 5,000,000 Gross Profit Margin = 76% 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: Operating Profit Margin = Earnings before Interest & Taxes / Sales 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? Operating Profit Margin = 450,000 / 2,000,000 Operating Profit Margin = 22.5%

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: Net Profit Margin = Net Income / Sales 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? Net Profit Margin = 500,000 / 2,200,000 Net Profit Margin = 22.7% 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.