Ratio Analysis Tutorial
- Ratio Analysis of Financial Statements
- Liquidity Ratios
- Turnover Ratios
- Profitability Ratios
- Profit Margin
- Gross Profit Margin Formula
- Operating Profit Margin Formula
- Net Profit Margin Formula
- EBIDTA Margin
- Return on Equity (ROE)
- Return on Capital Employed (ROCE)
- Return on Invested Capital (ROIC)
- Return on Total Assets (ROA)
- Return on Average Capital 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
- Revenue Per Employee Ratio
- Operating Leverage
- EBIT vs EBITDA
- Efficiency Ratios
- Dividend Ratios
- Debt Ratios
- Expense Ratios
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 Profit Margins? Profitability analysis is one of the most important part of the 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
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 margin 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 is stand on the hypothesis that while computing gross profit margin all expenditures are to be subtracted which are directly volatile with sales.
As an example of Gross Profit Margin, let us look at the chart below. This chart compares the Gross Margins of Amazon, Etsy, Alibaba and Ebay.
- We note that Ebay has highest Gross Margin Levels (~79.39%), followed by Alibaba and Etsy
- Amazon’s Gross Margins of 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 industry.
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 profit 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 operations of the company.
- The ratio is created to concentrate on the margin on profits due to business activities before 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 Operating Profit Margin, let us look at the chart below. This chart compares the Operating Profit Margins / EBIT Margins of Amazon, Etsy, Alibaba and Ebay.
- Alibaba and Ebay show a healthy operating margin levels (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 highers. 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 profit margin is computed below:
Net profit 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 profit 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 Profit Margin, let us look at the chart below. This chart compares the Operating Profit Margins / EBIT Margins of Amazon, Etsy, Alibaba and Ebay.
- 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 profit margin and operating profit 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. Income tax rate is assumed to be 50 %.
You are required to calculate the (a) Gross profit margin (b) Net profit margin (c) Operating profit Margin.
Solution to Profitability Margin – Example 1
Calculation of sales
Sales = 150 % of direct cost = $ 48,000 * 150 / 100 = $ 72,000
Calculation of Profits
|Less : Direct costs||48,000|
|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 operating profit margin
Operating profit 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 analysed the changes in profitability margin
Solution to Profitability Margin – Example 2
|Gross profit margin||Decrease||Decrease in Gross profit margin indicate sufficient funds are not avail for operating expenses and taxes. It states either increase in Sale price or diminishing of Direct expenses|
|Operating Profit Margin||Constant||Remaining Constant of operating profit margin indicates in spite of decline of gross profit margin, the company has benefitted in terms operating performance.|
|Net profit margin||Increase||Enhancing of net profit margin indicate that 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.
- The average Gross Margin for this peer group is around 46.8%, Average Operating Profit Margin is at 17.8% and Net Profit Margin is at 15.3%
- Facebook and Adobe has the highest gross Margin in this peer group. This is primarily due 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 exceptionally high Gross Margin.
- Salesforce.com Marketing and sales costs is 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.
- The average Gross Margin for this Utilities peer group is around 51.9%, Average Operating Profit Margin is at 19.0% and Net Profit Margin is at 10.6%
- We note that the Highest Gross Margins for Utilities sector is less than that of Technology Sector. This is expected primarily due to higher Direct costs (manufacturing, raw material, transmission etc) associated with the Utilities sector.
- Engie (ticker – ENGIY) is the only company that has negative operating profit margin (~4.6%) and negative net profit margin (~6.6)
- American Electric, Dominion Resources and Duke Energy has a robust Gross Profit Margin (> 60%) , Operating Margins (>20%) and Net profit Margins (>12%)
- Cash Ratio
- DSCR Ratio
- Financial Liabilities Ratio
- PE Ratio
- Price to Book Value Ratio
- Current Ratio
- Working Capital Ratio