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Why A Company’s Profitability Matters To You – Part 1
Education | 17 July 2014
By: Peter Ng
Articles (81) Profile

This is a series of three articles where each article will discuss on one of the three most widely used profitability ratios, namely gross profit margin, operating profit margin and profit before tax margin.

Other than assessing a company’s revenue growth which most would, an investor is highly encouraged to look into a company’s profitability.

Profitability is defined as how much of the remainder is left for a company to keep after deducting the different categories of costs on a sale transaction.

A company with growing revenue paired with a sinking level of profitability is a red flag for investors.

This is because profitability can affect the company in numerous ways, for instance, most companies would require resources to be re-invested back into its business in order to maintain certain competitive advantages which they may have.

Although not the deciding factor, the amount of profits also directly impacts the sustainability of dividends which an investor can collect from a company.

Gross Profit Margin
In this article, we will begin with gross profit margin.

Widely known as gross margin, this ratio is computed by dividing gross profit over revenue, where gross profit is obtained by subtracting cost of goods sold (COGS) from revenue.

The key in understanding this ratio lies in COGS. Under clause two of the International Accounting Standards, COGS refers to the cost of inventories recognised as expenses.

To put this simply, COGS is the aggregate costs incurred by a company which include the costs of the goods manufactured as well as any other costs involved before it is ready for sale or put into a company’s inventory.

For example, let’s picture a scenario involving a bookstore. Assuming that a publisher sells a book to the bookstore at $15 plus $5 in shipping charges, the bookstore will report $20 as COGS when the book is sold.

Elaborating further, $20 is how much the bookstore has incurred from purchasing the book, shipping it to the bookstore’s location and finally, putting the book up on its shelf where it is now ready for sale.

Interpretation
Gross margin is a useful measure to evaluate a company in a few ways.

First, a company which is able to command a higher gross margin would mean that it can charge a premium for a product it sells over another company.

It is likely that the company’s products have a certain competitive advantage over its competitors’ which consumers are willing to pay for despite its higher price.

For example, a Louis Vuitton handbag will be able to command a higher price compared to other bags of a comparable make quality which is mainly due to its brand equity or value.

Secondly, gross margin can serve as a measure to determine a company’s efficiency during the production process of its goods i.e. the higher the gross margin, the lower its COGS, which equates to a higher level of efficiency in the production process of a company.

The higher efficiency can be thought in a way like a defensive mechanism for a firm. The ability to maintain lower costs gives a firm the room to reduce price in the event of unforeseen circumstances like an economic slowdown while still maintaining a certain level of profitability.

Relevance
Do note that gross margin is only relevant for companies which produce or manufacture goods.

Therefore, service companies like an airline despite carrying a small amount of inventory like food and beverages to be served on board flights do not manufacture or produce goods in general.

A computed gross margin in this case, will result in a figure that is not only abnormally high but also not representative of the company’s underlying business.

As such, a more appropriate method is to use operating profit margin instead which will be discussed in the next part.

Further Help
Often, questions surface whereby investors may not be proficient or would simply prefer to have a source to countercheck on their calculations.

As such, we have provided both the subscribers and readers of the Shares Investment web platform and magazine with calculations such as gross profit margin (when applicable) as well as other relevant calculations and analytical content of a company. (See image below)

Gross Profitability Mention Within Corporate Profile of STATs Chippac

Backed by a strong interest in investments, Peter's research spans across a range of industries, with his focus placed on companies listed on the SGX.

Please click here for more information about this author.


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The Shares Investment editorial team welcomes constructive feedback on our coverage and content. We would also be delighted to answer any questions on the above article. Leave us a comment below, and we'll get back to you shortly!

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