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.