Financial Statement Analysis

- Profitability Ratios
- Profitability Ratios Formula
- Common Size Income Statement
- Vertical Analysis of Income Statement
- Profit Margin
- Profit Margin Formula
- Profit Percentage Formula
- Profit Formula
- Gross Profit Margin Formula
- Gross Profit Percentage
- Operating Profit Margin Formula
- EBIT Margin Formula
- Operating Income Formula
- Net Profit Margin Formula
- EBITDA Margin
- Degree of Operating Leverage Formula (DOL)
- NOPAT Formula
- OIBDA
- Earnings Per Share
- Basic EPS
- Diluted EPS
- Basic EPS vs Diluted EPS
- Return on Equity (ROE)
- Return on Equity Ratio
- Return on Capital Employed (ROCE)
- ROCE Formula (Return on Capital Employed)
- Return on Invested Capital (ROIC)
- Return On Investment (ROI)
- Rate of Return on Investment
- Return on Sales
- ROIC Formula (Return on Invested Capital)
- Return on Investment Formula (ROI)
- ROIC vs ROCE
- ROE vs ROA
- CFROI
- Cash on Cash Return
- Return on Total Assets (ROA)
- Return on Total Assets Formula
- Return on Average Capital Employed
- Capital employed Employed
- Return on Average Assets (ROAA)
- Return on Average Equity (ROAE)
- Return on Assets Formula
- Return on Equity Formula
- DuPont Formula
- Net Interest Margin Formula
- Earnings Per Share Formula
- Diluted EPS Formula
- Contribution Margin Formula
- Unit Contribution Margin
- Revenue Per Employee Ratio
- Operating Leverage
- EBIT vs EBITDA
- EBITDAR
- Capital Gains Yield
- Tax Equivalent Yield
- LTM Revenue
- Operating Expense Ratio Formula
- Overhead Ratio Formula
- Variable Costing Formula
- Capitalization Rate
- Cap Rate Formula
- Comparative Income Statement
- Capacity Utilization Rate Formula
- Total Expense Ratio Formula
- Markup
- Markup Percentage Formula

- Ratio Analysis (17+)
- Liquidity Ratios (29+)
- Turnover Ratios (17+)
- Efficiency Ratios (7+)
- Dividend Ratios (9+)
- Debt Ratios (26+)

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Profit Margin is an important profitability ratio used by the management, financial analysts and investors in order to know that how much profit the company against the sales made and is calculated by dividing the profits generated during the period by the sales.

**Profit Margin –** Let us look at the example of Etsy above. We note that the Gross Margin of the company is around 64.5%, however, its Operating Margin and Profit Margins are negative at -0.69% and -19.8%, respectively. **Why is this so?**

However, before we answer the question of “Why”, it is important to understand the meaning of terms – Gross margin, operating margins and profit margins!, Do you know about these Margins? Profitability analysis is one of the most important parts of financial analysis and research.

In this article, we look at Profit Margins in detail –

- Gross Profit Margin
- Operating Profit Margin or EBIT margin
- Net Profit Margin
- Profitability Margin Calculation – Examples
- Technology Sector – Profitability Margin Analysis
- Utilities Sector – Profitability Margin Analysis

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**Gross Profit Margin**

It is also known as gross margin or gross profit ratio. The gross profit margin is calculated as follows:

**Gross profit margin formula** = (Sales – cost of goods sold)/Sales or Gross profit/Sales

- The ratio measures the gross profit ratio on the total sales made by the company.
- The gross profit represents the excess of sales proceeds during the period under observation over their cost, before taking into account administration, selling and distribution and financing charges. The ratio measures the efficiency of the company’s operations and this can also be compared with the previous years’ results to ascertain the efficiency.
- When everything is normal, the gross margin of profit should remain unchanged, irrespective of the level of production and sales, as it stands on the hypothesis that while computing gross profit ratio all expenditures are to be subtracted which are directly volatile with sales.

As an example of the gross profit ratio, let us look at the chart below. This chart compares the Gross Margins of Amazon, Etsy, Alibaba, and eBay.

source: ycharts

- We note that eBay has the highest Gross Margin Levels (~79.39%), followed by Alibaba and Etsy
- Amazon’s gross profit ratios were stagnant until 2012 (~20%), however, its gross Margins have moved up steadily in the past three years (~33.04% in FY2016).

The margin of gross profit might be compared with that of competitors in the industry to assess the operational accomplishment respective to other players in the industry.

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**Operating Profit Margin or EBIT Margin**

It is also known as operating margin or operating profit ratio or EBIT Margin (Earnings before interest and taxes).

The operating margin is calculated as follows:

**Operating Profit Ratio Formula =** Operating profit/Sales or EBIT/Sales

Or (Net profit as per profit and loss account + non-operating expenses – non-operating incomes) * / Sales.

- This ratio estimates the effectiveness of the operations of the company.
- The ratio is created to concentrate on the margin on profits due to business activities before the deduction of tax and interest.
- This ratio reflects operating margin on profit on the total sales after deducting all expenses excluding tax and interest.

As an example of the EBIT Margin, let us look at the chart below. This chart compares the Operating Profit Margins / EBIT Margins of Amazon, Etsy, Alibaba, and eBay.

source: ycharts

- Alibaba and eBay show a healthy operating margin level (greater than 25%). However, Amazon just managed to be positive at the EBIT level.
- Additionally, we note that even though Etsy had a healthy Gross margin (approximately 64%,) its Operating Margin is negative (~0.69%).
- Etsy’s Marketing, Product Development, and General & Administrative costs are unusually higher. This results in a negative EBIT Margin.

source: Etsy SEC Filings

**Please note that Operating income can be thought of as the “bottom line” from operations**

**Net Profit Margin**

It is also known as net margin or ratio on net profit. The net margin is computed below:

Net margin formula = Profit After Tax (PAT)/Sales or Net profit/Sales

- This ratio reflects net margin on profit on the total sales after deducting all expenses covering interest and taxation too.
- One important point that we should not here is that Net margin can increase or decrease due to the presence of non-recurring items.
- It is, therefore, important to take those into account before we come to any conclusion.

As an example of Net Margin, let us look at the chart below. This chart compares the Operating Profit Margins / EBIT Margins of Amazon, Etsy, Alibaba, and eBay.

source: ycharts

- Alibaba and Ebay’s profitability is very high (greater than 20%).
- Amazon just managed to show a barely positive Net profit margin levels.
- Etsy, on the other hand, has a negative profit margin (~19.8%)

## Profitability Margin Calculation – Examples

Through the following illustration computation and measurement of various profitability margin like gross profit margin, net margin, and operating margin are provided.

#### Profitability Margin – Example 1

ABC Ltd. has made plans for the next year. It is estimated that the company will employ total assets of $ 80,000, 50% of the being financed by borrowed capital at an interest rate of 16 % per year. The direct costs for the year are estimated at $ 48,000 and all other operating expenses are estimated at $ 8,000. The goods will be sold to customers at 150 % of the direct costs. The income tax rate is assumed to be 50 %.

You are required to calculate the (a) Gross profit margin (b) Net profit margin (c) EBIT Margin.

**Solution to Profitability Margin – Example 1**

**Calculation of sales**

Sales = 150 % of direct cost = $ 48,000 * 150 / 100 = $ 72,000

**Calculation of Profits**

Particulars | Amount |

Sales | 72,000 |

Less : Direct costs | 48,000 |

Gross Profit |
24,000 |

Less : Operating Expenses | 8,000 |

Earnings before interest and tax (EBIT) or Operating profit |
16,000 |

Less : Interest on borrowed capital ( 16 % on 50 % on 80,000 ) | 6,400 |

Earnings after tax (EAT) | 9,600 |

Less : Tax @ 50 % | 4,800 |

Profit after Tax or Net profit |
4,800 |

**Calculation of Gross profit margin**

Gross profit margin = Gross profit * 100 / Sales = 24,000 * 100 / 72,000 = 100 / 3 = 33.33 %

**Calculation of Net profit margin**

Net profit margin = Profit after tax or net profit * 100 / Sales = 4,800 * 100 / 72,000 = 20 / 3 = 6.7 %

**Calculation of EBIT Margin**

EBIT Margin = Operating profit or EBIT * 100 / Sales = 16,000 * 100 / 72,000 = 100 / 6 = 16.67 %

#### Profitability Margin – Example 2

Z Ltd. has the following information

Particulars |
Year 1 |
Year 2 |

Gross profit margin | 21 % | 20 % |

Operating profit margin | 15 % | 15 % |

Net profit Margin | 10 % | 11 % |

You are required to interpret and analyzed the changes in profitability margin

**Solution to Profitability Margin – Example 2**

Particulars |
Direction |
Interpretation |

Gross profit margin | Decrease | The decrease in Gross profit indicates sufficient funds do not avail for operating expenses and taxes. It states either increases in Sale price or diminishing of Direct expenses |

Operating Profit Margin | Constant | Remaining Constant of operating margin indicates in spite of the decline of gross profit margin, the company has benefitted in terms of operating performance. |

Net profit margin | Increase | Enhancing of net profit margin indicate that a company is more effective in converting revenue into actual profit |

Technology Sector – Profitability Margin Analysis

Below is the Top 20 companies in the Technology sector with Market Capitalization of more than $25 billion.

source: ycharts

- The average Gross Margin for this peer group is around 46.8%, Average Operating Profit Margin is at 17.8% and the Net Profit Margin is at 15.3%
- Facebook and Adobe have the highest gross Margin in this peer group. This is primarily due to the fact that they don’t sell tangible products (no raw material as they are into software/internet where direct costs are less)).
- Though Apple has a Gross Margin which is way low in comparison to Facebook. This is because they have a higher direct cost (including the manufacturing, raw material, and direct labor costs). However, Apple does really well at the Operating level (~27.8%) and Profit Margin Levels (21.2%)
- Salesforce.com is the only company in the peer group that has a negative Profit Margin (~0.7%). This is despite the fact that it has an exceptionally high Gross Margin.
- Salesforce.com Marketing and sales costs are around 50% of the total revenue. With this unusually higher marketing expense, the company profitability margin suffers and is negative.

source: Salesforce SEC Filings

## Utilities Sector – Profitability Margin Analysis

Below is the list of Top 12 companies with Market Capitalization of more than $25 billion in the Utilities Sector.

source: ycharts

- The average Gross Margin for this utility peer group is around 51.9%, Average EBIT Margin is at 19.0% and the Net Margin is at 10.6%
- We note that the Highest Gross Margins for the Utility sector is less than that of the Technology Sector. This is expected primarily due to higher Direct costs (manufacturing, raw material, transmission, etc) associated with the Utility sector.
- Engie (ticker – ENGIY) is the only company that has a negative EBIT Margin (~4.6%) and a negative net margin (~6.6)
- American Electric, Dominion Resources, and Duke Energy has a robust Gross Profit Margin (> 60%), EBIT Margins (>20%) and Net Margins (>12%)