Margin analysis is a great way to understand the profitability of companies. But, like all ratios, margin ratios never offer perfect information. They are only as good as the timeliness and accuracy of the financial data that gets fed into them, and analyzing them also depends on a consideration of the company’s industry and its position in the business cycle. Then why not just use net income to determine profitability? Consider this example:
In 2008, railroad company Norfolk Southern (NSC) had an annual net income of $1.7 billion on sales of about $10.6 billion. Its major competitor, Burlington Northern Santa Fe (BNI) earned about $2.1 billion for the year on sales of about $18 billion.
Comparing the Burlington’s net earnings of $2.1 billion and Norfolk’s $1.7 billion shows that Burlington earned more than Norfolk, but it doesn’t tell you very much about profitability.
If you look at the net profit margin, or the earnings generated from each dollar of sales, you’ll see that Norfolk produced 16 cents on each dollar of sales, while Burlington returned less than 12 cents. This is one of the many reasons that we value Norfolk more than Burlington.
There are three types of profit margins:
(1) Gross margin indicates how efficiently management uses labor and supplies in the production process.
Gross Margin = (Sales – Cost of Goods Sold) / Sales
Companies with high gross margins will have a lot of money left over to spend on other business operations, such as research and development or marketing. Downward trends in the gross margin rate over time are a telltale sign of future problems facing the bottom line. It’s important to remember that gross profit margins can vary drastically from business to business and from industry to industry. A perfect example of varying ratios across different industries is the airline industry and software industry with gross margins of about 5% and 90%, respectively.
(2) Operating margin compares earnings before interest and taxes (EBIT) to sales, which shows how successful a company’s management has been in generating income from the operation of the business.
Operating Margin = EBIT / Sales
High operating profits can mean the company has effective control of costs, or that sales are increasing faster than operating costs. Some consider operating profit a more reliable measure of profitability than net profit margins since it is harder to manipulate with accounting tricks than net income. Operating margin will be always be less than gross margin because it accounts not only for the costs of goods sold (COGS), but also selling, general, and administrative (SG&A) costs.
(3) Net profit margin measures the profits generated from all phases of a business, including taxes. It comes as close as possible to summing-up in a single figure how effectively managers run the business.
Net Profit Margin = Net Profits after Taxes / Sales
Companies with high net profit margins usually have one or more advantages over its competition, a bigger cushion to protect themselves during downturns, and the ability to improve market share during downturns which leaves them even better positioned when things improve again.
In 2008, railroad company Norfolk Southern (NSC) had an annual net income of $1.7 billion on sales of about $10.6 billion. Its major competitor, Burlington Northern Santa Fe (BNI) earned about $2.1 billion for the year on sales of about $18 billion.
Comparing the Burlington’s net earnings of $2.1 billion and Norfolk’s $1.7 billion shows that Burlington earned more than Norfolk, but it doesn’t tell you very much about profitability.
If you look at the net profit margin, or the earnings generated from each dollar of sales, you’ll see that Norfolk produced 16 cents on each dollar of sales, while Burlington returned less than 12 cents. This is one of the many reasons that we value Norfolk more than Burlington.
There are three types of profit margins:
(1) Gross margin indicates how efficiently management uses labor and supplies in the production process.
Gross Margin = (Sales – Cost of Goods Sold) / Sales
Companies with high gross margins will have a lot of money left over to spend on other business operations, such as research and development or marketing. Downward trends in the gross margin rate over time are a telltale sign of future problems facing the bottom line. It’s important to remember that gross profit margins can vary drastically from business to business and from industry to industry. A perfect example of varying ratios across different industries is the airline industry and software industry with gross margins of about 5% and 90%, respectively.
(2) Operating margin compares earnings before interest and taxes (EBIT) to sales, which shows how successful a company’s management has been in generating income from the operation of the business.
Operating Margin = EBIT / Sales
High operating profits can mean the company has effective control of costs, or that sales are increasing faster than operating costs. Some consider operating profit a more reliable measure of profitability than net profit margins since it is harder to manipulate with accounting tricks than net income. Operating margin will be always be less than gross margin because it accounts not only for the costs of goods sold (COGS), but also selling, general, and administrative (SG&A) costs.
(3) Net profit margin measures the profits generated from all phases of a business, including taxes. It comes as close as possible to summing-up in a single figure how effectively managers run the business.
Net Profit Margin = Net Profits after Taxes / Sales
Companies with high net profit margins usually have one or more advantages over its competition, a bigger cushion to protect themselves during downturns, and the ability to improve market share during downturns which leaves them even better positioned when things improve again.
Comparing a company’s gross and net margins provides a sense of its non-production and non-direct costs like administration, finance, and marketing costs. Software business has an exceedingly high gross margin of 90%, but a net profit margin of only 27%. This means its marketing and administration costs are very high, while its cost of sales and operating costs are relatively low.
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Peter J. Lazaroff
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Peter J. Lazaroff
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