Profitability Ratios II – Fundamental Analysis

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As explained in the previous article Profitability ratio is used to evaluate the company’s ability to generate income as compared to its expenses and other cost associated with the generation of income during a particular period.

We have already covered the “ Return Ratio” in the previous article.

In this article we cover the second part of the profitability ratios- the “Margin Ratios

Margin Ratios– represents the ability of a firm to generate profits from its sales, when measured at various stages. Margin Ratios are as follows:

Gross profit margin: measures pure profit that is earned from selling the inventory that is directly used in paying other operating expenses. This ratio compares the gross margin of the business to its net sales.

A high gross profit margin ratio reflects a higher efficiency of core operations, meaning it can still cover operating expenses, fixed costs, dividends, and depreciation, while also providing net earnings to the business. While, a low-profit-margin indicates a high cost of goods sold, which can be attributed to adverse purchasing policies, low selling prices, low sales, stiff market competition, or wrong sales promotion policies.

EBITDA Margin stands for Earnings before Interest, Taxes, Depreciation, and Amortization. It represents the profitability of a company before taking into account non-operating items like interest and taxes, as well as non-cash items like depreciation and amortization. The margin does not include capital expenditure or changes in working capital.

The benefit of analysing a company’s EBITDA margin is that it is easy to compare it to other companies since it excludes expenses that may be volatile or somewhat discretionary. However net profit and cash flow are better indicators of a company’s performance.

Operating Profit Margin – the costs of producing the product or services that are unrelated to the direct production of the product or services, such as overhead and administrative expenses. This ratio helps in evaluating the operating efficiency of the company i.e. EBIT (income before interest and taxes). It helps in measuring the return on the sales generated by the operations of the business.

Companies with high operating profit margins are generally more well-equipped to pay for fixed costs and interest on obligations, have better chances to survive an economic slowdown, and are more capable of offering lower prices than their competitors that have a lower profit margin. Operating profit margin is frequently used to assess the strength of a company’s management since good management can substantially improve the profitability of a company over and above its operating costs.

The following table shows us the Operating Profit Margin Ratio of HDFC and ICICI over the past 5 years:

2014 2015 2016 2017 2018
HDFC 1.35 2.51 2.56 3.25 2.82
ICICI -1.39 -2.03 -10.61 -17.91 -19.36

 

In the above table we see- the operating profit for HDFC has been increasing, which reflects the ability of the business in generating profits. However, on the other side not only is the operating profit for ICICI negative, but it has also been drastically declining as well.

Net Profit Margin: measures the overall profitability of a company considering all direct as well as indirect cost. A reason to use the net profit margin as a measure of profitability is that it takes everything into account. A high ratio represents a positive return in the company and better the company is.

A drawback of this metric is that it includes a lot of “noise” such as one-time expenses and gains, which makes it harder for compatibility sake.

The following table shows us the Net Profit Margin Ratio of HDFC and ICICI over the past 5 years:

2014 2015 2016 2017 2018
HDFC 20.61 21.07 20.41 20.99 21.79
ICICI 22.20 22.76 18.44 18.09 12.23

 

Looking at the Net Profit Margin ratio of the two bank’s we can see that the Net Profit for the HDFC Bank has been quite stable. Whereas for ICICI have been falling in the past 5 years.

Cash Flow Ratio: This ratio calculates the cash flow generated from the regular activities of the business as a percentage of Net Sales. It measures the ability of the company to convert sales into cash. The higher the percentage of cash flow means the more cash available from sales to pay for suppliers, dividends, utilities, and service debt, as well as to purchase capital assets.  Negative cash flow, however, means that even if the business is generating sales or profits, it may still be losing money. In the instance of a company with inadequate cash flow, the company may opt to borrow funds or to raise money through investors in order to keep operations going.

Adequate cash flow is necessary as this enables the company to take advantage of the extra growth opportunities.

 

Points to remember:

  1. Profitability ratio helps is getting the insights of the business by indicating the sufficiency of profits.
  2. The Management of the business also needs to closely follow these ratios to measure both its own performance and how the other peer companies are performing.
  3. Different profitability ratios measure different aspects of the business and help the management to work more efficiently to generate more profits.

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