Profitability Ratios- Analyzing An Income Statement
Profitability reflects the final result of a company’s business operations. Profitability ratios are also called income statement ratios since most of the items used in their calculations are picked up from the income statement. Profit margin ratios and rate of return ratios are the most commonly used profitability ratios. A comparison of profitability ratios with other competitors in the same industry can reveal relative strengths or weaknesses of a business.
Gross Margin Ratio
The first of the profitability ratios we will cover is gross margin ratios. These measure the margin remaining after meeting all the manufacturing expenses including labor, material and other manufacturing costs, the costs which are directly related to the business. It also indicates the efficiency of production and pricing strategies of a company. The range of gross margin varies across industries. The service industry will have a higher gross margin ratio compared to the manufacturing industry as they have lower raw material and manufacturing costs. The ratio is calculated as follows:
Gross margin profitability ratios also indicate the amount of cash that is available to pay the company’s overhead expenses. A company with a higher gross margin can maintain a decent level of profit, as long as the overhead costs like rent, utilities and the like are controlled.
Trends of the gross margins over a period of time provide a more meaningful insight into the company’s strengths rather than a gross margin figure for only one year. A company earning a consistently high gross margin over a few years is in a better position to face a downturn in business. However, a company earning a decent but consistent gross margin is considered to be more stable compared to a company boasting a high, but volatile gross margin. Significant fluctuations in a company’s gross margin profitability ratios can be a potential sign of fraud or accounting irregularities.
Operating profit margin measures the profitability of a company’s normal and recurring business activities. Operating profits are the profits earned before interest, taxes and extraordinary expenses. It does not include the impact of management’s financing decisions. This profitability ratio indicates the general health of the company’s core business. It is calculated as follows:
Nonrecurring and one-time expenses, such as cash paid out in a lawsuit settlement or goodwill write-offs are excluded from the operating profits equation, as they do not represent the company’s true operating performance.
A couple more points on operating margin, these profitability ratios are also considered to be an important measure of the management’s efficiency. A company with lower levels of fixed costs tends to have higher operating margins. Having lower fixed costs provides management with more flexibility in determining prices. Moreover, a healthy operating margin is important for any business as it provides an additional measure of safety during tough times.
Significant increase in operating margin is not necessarily a positive sign
Certain expenses like depreciation are subject to management control, and can be manipulated to appear as an increasing operating margin. Changing the depreciation methods and rates can show a temporary increase in operating margin.
Our profitability ratio number three is the EBITDA margin, which represents earnings before interest, tax, depreciation and amortization. As mentioned above, management can manipulate the bottom line by changing the depreciation rates. Also, manufacturing companies generally have higher depreciation figures compared to service companies. Additionally, financing decisions can alter the effective tax rate paid by a company. These factors make it hard to create a meaningful comparative analysis of a company with its competitors and other industry players. Hence, the EBITDA profitability ratio is a good measure for comparing companies across different industries. It is calculated as follows:
EBITDA can be calculated by adding depreciation figures to the operating margin figure
This profitability ratio is useful when comparing companies which carry large amount of fixed assets subject to heavy depreciation charges such as a mining company or an infrastructure company. It is also useful for comparing companies in mature industries that are in a consolidation phase. Companies in consolidating industries tend to acquire significant tangible and intangible assets, such as a brands and copyrights, which are subject to large amortization charges.
As EBITDA measures the income that is available to pay interest charges, the EBITDA margin is very important to creditors and financial institutions. Companies with higher EBITDA margins are considered to be less financially risky than companies with low levels of EBITDA margins. In practice, the EBITDA margin is used only while analyzing large companies with significant depreciable assets, and for companies with a significant amount of debt financing.