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Lesson 11: Profitability Ratios, Gross Profit Margin

Profitability Ratios, Gross profit margin, Fundamental analysis

Profitability Ratios, Gross profit margin, Fundamental analysisWith this article, we start to see the profitability ratios. Profitability ratios are arguably the most widely used ratios in investment analysis. They include the ubiquitous “margin” ratios, such as gross, operating and net profit margins. These ratios measure the company’s ability to earn an adequate return. When analysing a company’s margins, it is always prudent to compare them against those of the industry and its close competitors. Margins will vary among industries.

Companies operating in industries where products are mostly “commodities” (products easily replicated by other companies) will typically have low margins. Industries that offer unique products with high barriers to entry, generally have high margins. Also, companies may hold key competitive advantages leading to increased margins.

The first profitability ratio I analyse is the Gross Profit Margin. The gross profit margin measures how much gross profit is generated for each dollar of sales. The gross profit has to cover the company’s operating expenses, depreciation and amortization, finance cost, and taxes.

It will vary significantly between companies in different industries. For example, companies with significant fixed assets will typically have a higher gross profit margin than companies with low fixed assets such as service companies.

Gross profit margin is simply gross profits (sales less cost of goods sold) divided by net sales. The ratio reflects pricing decisions and product costs.

Profitability Ratios, Gross profit margin, Fundamental analysis

 

For most firms, gross profit margin will suffer as competition increases. If a company has a higher gross profit margin than is typical of its industry, it likely holds a competitive advantage in quality, perception or branding, enabling the firm to charge more for its products. Alternatively, the firm may also hold a competitive advantage in product costs due to efficient production techniques or economies of scale.

Keep in mind that if a company is a first mover and has high enough margins, competitors will look for ways to enter the marketplace, which typically forces margins downward.

 

Example

A company has sales in the amount of $ 240,000 and cost of sales in the amount of $ 165,000, which gives a gross profit margin of 31.25%. A gross profit margin of 31.25% means that for each $ 100 of sales generated by the company, $ 31.25 is gross profit to cover the company’s operating costs.

Profitability Ratios, Gross profit margin, Fundamental analysis

 

A change in the company’s gross profit margin could be a result of price pressure from competitors, meaning that the company maintains the current cost structure while lowering sales prices. It could also be a result of higher cost of sales.

This could be true if goods are imported, which typically adds another layer of expenses to the cost of sales, that is, fluctuations in foreign currents. Often, it can also be explained by a shift in product mix. It is therefore important to look at the gross profit margin on each product or product line.

In the next article, we will see e new profitability ratio.

 

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