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Profitability Margin Ratios

This chapter explains the different profitability terms & ratios in fundamental analysis of stocks. Learn the meaning of the most important profit margin ratios.

Gopal Kavalireddi
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Gross Profit (GP)

The first measure of profit termed as the Gross Profit refers to the amount of money earned by the company, after deducting the cost of goods sold (COGS) from its net sales.

Gross Profit is calculated as:

GP = Net Sales – COGS,

COGS is the sum of all direct costs, which are fixed and variable costs, exclusive of selling, general and administrative expenses.

Gross profit evaluates the efficiency of a company in managing its labor and material supplies used for the production of goods. Higher the gross profit, better the production efficiency of the company.

 

Gross Profit Margin (GPM)

When the gross margin is evaluated as a percentage of net sales, it is termed as the Gross Profit Margin.

Gross Profit Margin is calculated as:

GPM = (Net Sales – COGS) / Net Sales

Gross profit margin is an indicator of the company’s ability to controls the cost of its inventory, manufacturing of its products and subsequently, to pass on the costs to its customers. Higher the gross profit margin, better is the financial health of the company.

 

Contribution Margin (CM)

Contribution Margin is the excess amount of net sales post deduction of the variable product costs and the variable period expenses. The variable costs include materials and labour.

Contribution Margin is calculated as:

CM = Price of the product – Variable cost of the product

The contribution margin helps in assessing the amount of revenues left, to cover fixed costs and to earn a profit. The contribution margin is a measure of assessing the efficiency of a company to manufacture its products while maintaining a low level of variable costs.

This margin is more useful to the company in improving its internal procedures related to the production process and less useful to the general investors. The Contribution Margin Ratio is the contribution margin expressed as a percentage of net sales.

 

Operating Profit (OP)

Also referred to as Earnings before Interest and Taxes (EBIT), Operating Profit is the amount of profit generated by the company through the course of its normal business operations, before deducting interest and taxes.

Operating Profit is calculated as:

OP = Gross Profit – Operating Expenses

Operating expenses are represented by Selling, General and Administrative expense (SG&A), including depreciation and amortization.

Operating profit measures both, the overall demand for the company’s products/services – represented by sales, and the company’s efficiency in delivering those products/services – represented by costs. While positive operating profit indicates the overall profit potential of a business, it is not definitive for a company to post net profits. Even with high debt, a company may show a positive operating profit, while it can post a loss at the net level due to high finance costs.

 

Operating Profit Margin (OPM)

Also referred to as the Return on Sales (RoS) ratio, Operating Profit Margin is the ratio of operating profit to the net sales of a company.

Operating Profit Margin is calculated as:

OPM = (Gross Profit – Operating Expenses) / Net Sales = Operating Profit / Net Sales

OPM is a measure of the efficiency of the profit generation of a company. An increasing operating margin over a time period implies improving profitability. A company which is more efficient is controlling its overall costs will have a higher operating margin.

 

Net Profit (NP)

A better measure of profitability, represented by the last line of the profit and loss statement, Net Profit of a company is the total revenue leftover after deducting all the costs of doing business for the company. These costs include cost of goods, operating expenses, other expenses, interest expenses, and taxes.

Net profit also referred to as the bottom line, is calculated as:

NP = Total Sales – Total Expenses

Net profit is one of the most important measures, as it plays a larger role in ratio analysis and financial statement analysis. Also, based on the quantum of net profits, the company announces dividends to its shareholders. Higher the net profit, higher is the earnings per share (EPS) of the company. Based on the EPS, investors make an appropriate decision with respect to investing in the shares of the company.

 

Net Profit Margin (NPM)

When the net profit is evaluated as a percentage of sales, it is termed as Net Profit Margin.

Net Profit Margin is calculated as:

NPM = (Total Sales – Total Expenses) / Total Sales

Net profit margin is also simply referred to as profit margin.

 

Cash Flow Margin (CFM)

A lesser-known profitability ratio, the Cash Flow Margin indicates the ability of the company to convert its sales into cash. Expressed as a percentage, this ratio highlights the association between cash flows from operating activities and the sales generated by the company.

Cash Flow Margin is calculated as:

CFM = Cash flow from Operating Activities / Net Sales

Higher the percentage of cash flow implies higher the availability of cash from sales, to pay the suppliers, utilities, dividends, and debt as well as for purchasing fixed assets. At the same time, a negative cash flow implies that even with the business generating sales, it is still losing money. This is not an appropriate situation to be in for the company.

 

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Responses

Vicky Rao commented on April 26th, 2019 at 10:36 AM  
Which of the ratios mentioned above would you deem the most important for someone who has just started looking into stocks and trading?


tejas commented on May 6th, 2019 at 12:12 PM  
If you have just started, it's better to stick to the basics.
1. Gross Profit Margin
2. Net Profit Margin


Aman commented on May 6th, 2019 at 10:25 AM  
Are all the above-mentioned ratios important for trading as well?


tejas commented on May 6th, 2019 at 12:13 PM  
Hi Aman, financial ratios are not very useful for trading as such. Traders look at other parameters while entering and exiting positions as explained in the technical analysis module.


Deepak commented on August 6th, 2020 at 1:20 PM  
Could you throw some light on advanced financial analysis?


Deepak commented on August 6th, 2020 at 1:24 PM  
Worthy, would like to see some advanced analysis .


ICE Deepak Ojha commented on August 6th, 2020 at 1:26 PM  
Please some advanced practices


Anish.raj commented on August 18th, 2020 at 1:15 PM  
Good


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