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Saturday, June 20, 2009

Profit Margin Ratios


Profitability ratios are used by investors and analysts to evaluate a company’s ability to generate earnings as compared to its competitors and other industry players. They also highlight the strength and efficiency of a company’s business model. There are two types of profitability ratios; profit margin ratios and rate of return ratios. While profit margin ratios are used to judge the efficiency with which the company earns profits, rate of return ratios provide information of the efficiency with which the company employees its assets and other available resources. Comparison of profitability ratios with other competitors in the same industry reveals the relative strengths or weaknesses of the business. Some of the most commonly used profit margin ratios are Gross Margin ratio, Operating Margin ratio, EBITDA ratio and Net Profit Margin ratio.

Gross Margin ratio:


Gross margin ratio indicates the efficiency of production and pricing strategies applied by a company. In simple terms, it measures the margin left after meeting all the manufacturing expenses including labor, material and other manufacturing costs i.e. the costs which are directly related to the business. Going by this definition it can be assumed that service industry players will normally have higher gross margins as compared to players in manufacturing industries. This is primarily because they have lower manufacturing costs. Moreover, range of gross margin varies across industries. The ratio is calculated as follows:

Gross Margin Ratio = Net Sales – Cost of Goods Sold

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Net Sales


Trend of the gross margins over a period of time provides a better meaningful insight into the business strength rather than a single year’s gross margin figure. A company earning a consistently high gross margin over couple of years is in a better position to face the downturn in business cycles. However, a company earning lower but a consistent gross margin over time is considered to be more stable compared to a company boasting higher but a volatile gross margin. Significant fluctuations in the gross margin figure can be a potential sign of fraud or accounting irregularities.

Operating Margin

Operating profit margin measures the profitability of a company’s normal and recurring business activities. It enables the analyst to judge the efficiency of a company’s core business. Since operating profits do not include interest and taxes, this ratio does not indicate the effect of management’s financing decisions and is calculated as follows:

Operating Profit Margin = Gross Profit – Operating expenses

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Net Sales

Operating margin is a measure of management’s efficiency. By applying low levels of fixed costs in its cost structure a company can maintain a high level of operating margin. This is important primarily because lower fixed costs grant management more flexibility in determining prices and acts as a measure of safety during tough times. However, it is important to note that nonrecurring and one-time expenses, such as cash paid out in a lawsuit settlement and goodwill write-offs should be excluded while calculating operating margin ratio. They do not represent a company's true operating performance and can result in misleading conclusions.

Tuesday, June 9, 2009

Challenges of the Indian IT Service Industry

Recession in the global economy has directly affected an industry which has historically grown at double digits over the last decade; the Indian IT Service sector. Pricing and margins for tier 1 players like Infosys, Wipro, TCS, Tech Mahindra, HCL Tech and Cognizant are down by approximately 2% to 4%. The number of deals signed by the industry has also reduced drastically this year.

Some of the most important customers of Indian IT industry are from US and Europe which continue to be gripped by growing recessionary pressures, particularly the Banking and Insurance sectors. Recessionary pressures have forced them to lower their technology spending and shift to a fixed pricing and transaction based model. Gartner expects the IT spending to reduce to $3.2 trillion for 2009 from $3.4 trillion last year. Despite this, most of the contracts of Indian IT Service industry continue to be project based and discretionary. Clients have started consolidating their vendors and prefer end-to-end service provider rather than a discretionary service provider. They are increasingly involving senior management in decision making which has further extended decision and sales cycles. However, industry players are slowly shifting to transaction based models and longer-term annuity contracts. They now face the challenge of expanding their global delivery platforms and inorganic growth now seems to be the fastest and most efficient route to achieve this end.

Another major issue faced by this industry is talent crunch and high training costs. Infosys sacked 2100 employees and has announced plans to hold back promotions and pay hikes this year. To reduce training and bench costs which are considered to be the most inefficient cost areas, HCL Tech has introduced 'Just-in-Time' hiring strategy and also reduced the number of freshers employed. Lack of innovation also is an area concern of the industry as players continue to provide the same services. India was once a favorite outsourcing destination for BPO and IT services. Until 2008, the Indian IT service industry held a 51% market share in global outsourcing model. However, cost competitiveness and productivity benefits are slowly evaporating and as per McKinsey, talent crunch and lack of innovation will result in India losing 10% of its market share to other low cost countries like China and Philippines which are creating their own global delivery models.

Protectionist policies by the US government continue to threat the IT sector. Moreover, European countries are also considering adopting protectionist policies in a bid to increase local jobs and gain tax payers' confidence. Besides taking away the tax breaks, companies that have received federal bail out money now need to prove the lack of technical talent at home before they outsource work to locations like India.

To further aggravate the problems, unfavorable currency movements have played a spoil sport. Foreign exchange losses of top tier India IT companies range from Rs.201 crores for HCL Tech to Rs.781 crores for TCS. Industry experts opine that the Indian IT service sector will recover only once the global economy recovers. To sustain in such highly competitive market, players need to diversify and look for new revenue sources and opportunities to consolidate and move up the value chain.

Financial Ratio Analysis

Financial Ratio Analysis also referred to as ‘Quantitative Analysis’ is considered to be the most important step while analyzing a company from an investment perspective. It is a study of ratios between various items in financial statements. Ratios are classified as profitability ratios, liquidity ratios, asset utilization ratios, leverage ratios and valuation ratios based on the indications they provide. Balance sheet, Income Statement and Cash Flow Statements are the most important financial statements and if properly analyzed and interpreted can provide valuable insights into a company’s business.

Financial Ratios is commonly used by current and potential investors, creditors and financial institutions to evaluate a company’s past performance to spot trends in a business and to compare its performance with the average industry performance. It also enables them to identify strengths and weaknesses of a business and to justify further investments in the business. Internally, managers use these ratios to monitor performance and to set specific goals, objectives, and policy initiatives.

While analyzing a company from financial point of view, some of the common questions which an investor has are:

  1. How did the company perform over the last couple of years and what were the returns it generated for the previous stakeholders?
  2. How was the performance relative to the industry it belongs to?
  3. Does the company have enough liquidity to overcome any short-term market fluctuations?
  4. How does the company handle its working capital?
  5. How risky is it to invest in this company?

These are the most common questions any investor has in his mind when he looks at the financial statements of a company he plans to invest in. While massive amount of numbers in a financial statement may be bewildering and intimidating to a layman investor, Financial Ratio Analysis enables him to understand these numbers in an organized fashion.

The most important assumption the analyst should make sure while drawing conclusions based on financial ratios is that the accounting policy of the company has remained constant over the period of review. Changes in accounting policies may distort the indications provided by the ratios. For example, companies that intend to enhance their asset return ratios may change the depreciation accounting method applied; thus providing misleading asset return ratios. The analyst should therefore make adjustments for any material differences in accounting policies before evaluating ratios. Similarly, it is equally important to allow for any material differences in accounting policies while comparing the company with other industry players.

While ratios do provide valuable insight into the company’s past performance and potential problems, they cannot be evaluated on a stand alone basis. For a thorough examination of a business, the analyst must read between the lines and check for any major fluctuations in any line item in financial statements. Non-recurring items and extra-ordinary expense or income items must be excluded for meaningful analysis. Similarly, wide fluctuations in revenue figure or expense figure should be justified. Here the importance of Note to financial statements cannot be overemphasized. Information provided in these notes to financial statements can be very helpful in avoiding inappropriate investment decisions due to misleading financial ratios.

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