Specialized Tools of financial analysis (2)
Besides breakeven analysis and contribution margin analysis, profitability analysis relates to specialized tools of financial analysis and reflects the results of the profit-seeking activities of the enterprise
Gross margin analysis
Gross margin analysis provides special insights into the operating performance of a company. It helps in evaluating overall gross margin by product mix.
Profitability refers to the ability of a company to earn income. Net income is the single most significant measure of profitability. Investors and creditors have a great interest in evaluating the current and prospective profitability of an enterprise. Profitability ratios have been developed to measure operational performance. The numerator of the ratios consists of profits according to specified definition (gross margin, operating income, net income); the denominator represents a relevant investment base.
Gross profit margin
The gross profit margin reveals the percentage of each dollar left over after the business has paid for its goods. The higher the gross profit earned, the better. Gross profit equals net sales less cost of goods sold.
Gross profit margin = Gross Profit / Net Sales
In 2017, the ratio is $460,000/$1,530,000 = 0.30
The ratio was 0.287 in 2016 ($416,000/$1,450,000). The rise in this ratio indicates the business is earning more gross profit on each sales dollar. The reasons for the increase may be many, including a lower relative production cost of goods sold.
Operating expenses to sales ratio
Operating expenses to sales ratio is a useful measure of operating efficiency. A higher value should be investigated to determine whether cost cutting or downsizing is necessary.
Operating expenses to sales ratio = Operating expenses / Net sales
2017 ratio: $301/$1,530 = 19,67%
2016 ratio: $276/$1,450=19.03%
Trend: deteriorating
Profit margin on sales
Profit margin on sales indicates the dollar amount of net income the company receives from each dollar of sales. This ratio reflects the ability of the company to control costs and expenses in relation to sales.
Profit margin on sales = Net income / Net sales
2017 ratio: $95,500/$1,530,000 = 6,2%
2016 ratio: $81,000 / $1,450,000 = 5.6%
The profit margin on sales increased significantly from 20x6 to 20x7. The reasons for this change relate primarily to factors related to revenue and expenses reported on the income statement.
Net operating margin
The net operating margin on sales ratio excludes non-operating items, such as interest expense, gains and losses on disposal of discontinued operations, and extraordinary items.
Net operating income = Operating income/Net sales
The gross profit to sales ratio is helpful in evaluating operating performance and income. Gross profit is the difference between selling price (sale) and the actual cost of goods sold. This ratio indicates whether or not the company is maintaining or improving its markup on costs, which is a major business objective.
Financial Management point of view on profitability analysis
The profit margin indicates the success of management in generating earnings from its operations. The higher the profit margin on each sales dollar generated, the better the company is doing financially. Profit may also be increased by controlling expenses. A high profit margin is desirable because it indicates that the company is earning a good return on its cost of merchandise sold and operating expenses.
Investors and Creditors point of view on profitability analysis
By examining the company’s profit margin relative to previous years and to industry norms, one can evaluate the company’s operating efficiency and pricing strategy as well as its competitive status within the industry. The ratio to income to sales is important to investors and creditors because it indicates the financial success of the business. The “bottom line” is what counts. Profit margin reveals the entity’s ability to generate earnings at a particular sales level. Investors will be reluctant to invest in an entity with poor earning potential, since the market price of stock and future dividends will be adversely affected. Creditors will also shy away from companies with deficient profitability, since the amounts owed to them may not be paid.