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Why Does A Company’s Profitability Matter To You – Part 2
Education, Featured | 15 August 2014
By: Peter Ng
Articles (81) Profile

Having previously discussed the importance for an investor to assess a company’s gross profit margin, let us take a step further and understand a second measurement of profitability, operating profit margin.

What Is Operating Profit Margin?
Also known as operating margin, this ratio measures the profitability of a company after taking into account of all costs involved for the supply of goods and services, excluding interest payments on bank loans and taxes.

Excluding the amount paid for interest and taxes, the residual amount after deducting all other expenses from a company’s revenue will leave us with earnings before interest and taxes (EBIT) or operating profit.

Finally, dividing EBIT by revenue will give us the operating margin a company for that financial period.

Gross Margin Versus Operating Margin
For a company that produces goods and holds an inventory on its balance sheet, the relevant gross and operating margins can be computed from a company’s income statement, as it conducts business activities and subsequently recognises revenue.

An investor is encouraged to spot for anomalies between the two profitability ratios and seek to understand their possible causes. One example is a growing level of gross margin accompanied by sinking operating margin.

A growing trend of gross margin could signal rising improvements in a company’s efficiency towards cost control and purchase of raw materials in the production process.

However, as gross margin only provides a measure of the company’s efficiency up till the point where goods are ready for sale, it does not take into account of other expenses incurred from the company’s business operations.

Using our previous bookstore example, gross margin is a relevant measure of the company’s cost from purchasing, shipping and any other costs such as the logistics involved, before a book is placed on the bookshelf and ready for sale.

Nonetheless, the computation of gross margin does not include expenses such as rental incurred for the bookstore premise, peripherals to accompany the sale of products (fanciful carrier to bag a shopper’s purchase) and labour costs (the well-groomed sales assistant at the counter who collects money from a purchase).

In addition, it is advisable for an investor to identify at least another company, in order to make comparisons on the different items of expenses before forming a conclusion.

For instance, an increase in labour costs incurred by the company could be attributed to poor labour management on hindsight. However, if other competitors are experiencing the same phenomenon, this could be due to other causes such as a shortage of workers or even an industry-wide increase in wages.

Companies Without Gross Margin
There are companies such as service providers who do not carry inventory or those that hold inventory but only serve as a complement for the provision of services such as an airline.

For cases like these, it is impossible or simply not relevant to compute the gross margin of a company. Instead, operating margin would have to be computed in order to assess the company’s profitability.

An example would be VICOM whose primary business activities involve the inspection and survey of vehicles. As the company does not produce or sell any goods, an investor will not be able to compute the gross margin of a company engaging in such line of business.

Source: Company Financial Statement

Referring from the company’s financial statement, we will be able to compute VICOM’s operating margin to be 33 percent and 33.6 percent in 1H13 and 1H14 respectively.

On top of maintaining the company’s operating margin at the 33 percent level between the two periods, total operating expenses have also grown lesser compared to the increase in revenue. In this case, the management has performed up to speed.

Items To Be Removed From EBIT
Furthermore, investors should pay attention that interest income is excluded from the calculation of operating profit as this amount is not an inflow attributed to the company’s operations.

Other items that should be excluded from the calculation of operating profit include profits from joint ventures and associates as well as other income arising from dividends and rental etc.

The key is to query and understand whether an item is a result of a company’s operations, if it does not, remove it. For instance, if it is just cash deposits generating interests in the bank account, it is most certainly not.

In the next and final part of the series, we will incorporate items on the balance sheet to further evaluate the profitability of a company by assessing its return on equity and return on assets.

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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