Profit margin :

We have seen earlier that there are many measures of profit such as net profit, operating
profit, gross profit, etc. When we express these as percentage of sales, we obtain profitability
measures which can be used for assessing the operating performance of the company

Gross profit margin = Gross profit

------------------
Net sales

Gross profit = Net sales – Cost of goods sold

(sometimes gross profit is also measured as PBDIT i.e. profit before depreciation, interest
and tax)

Net profit margin = Net profit

------------------
Net sales

Operating profit margin = Operating profit

------------------------
Net sales
Gross profit is of more importance to production department personnel as it relates sales
and cost of goods sold. For marketing personnel, operating profit is more relevant since it
includes expenses such as selling, marketing, distribution expenses. Net profit is important
to finance personnel since it is a measure of overall efficiency of the company.

Visit creditappraisal.in

www.dummies.com has a short but useful post on gross profit. The link to the file is
available on www.creditappraisal.in under Articles tab.

Gross profit is a good measure for comparing performance of companies in the same
industry. This is because other profits such as operating profit or net profit take into account
interest, tax and other expenses. These expenses depend on level of debt of the company, tax
rate concessions, etc. If the performance of two companies is exactly the same operations
wise and efficiency wise but one company pays less tax because the government offered it
concession for being located in backward / underdeveloped region, the net profit for these
companies will be different whereas gross profit will be same. See the following example.
Company paying regular tax Company paying concessional
at 30% tax at 20%
Sales (A) 1000 1000

Raw material 600 600

Labour 150 150
Other direct expenses 100 100
Add : opening stock of 50 50
wip
Less : closing stock of 60 60
wip
Cost of production 840 840
Add : opening stock of 90 90
wip
Less : closing stock of 95 95
wip
Cost of goods sold 835 835
Interest 0 0
Sub total (B) 835 835
Operating income (A-B) 165 165
Add : non operating 0 0
income
Less : non operating 0 0
expenses
Profit before tax 165 165
Tax 49.5 33
Net profit 115.5 132.0

In the above table, both companies are performing exactly the same except that there is
difference in tax due to concession offered by the Government for one company which is
located in backward area. Now suppose you are the promoter and both the above
companies are yours. You now want to give incentive to the CEO of one of the above two
companies who has performed better. Which would be your choice? Though net profit of the
second company is higher, is it because of the better performance of that CEO? It is your
decision as a promoter to have the second unit in a backward region that has resulted in
concessional tax for the second company. If you take out that tax part, are not the two
companies performing exactly similarly? Now take this scenario.
Company paying regular tax Company paying
at 30% concessional tax at 20%
Sales (A) 1000 1000

Raw material 600 600

Labour 140 150
Other direct expenses 95 100
Add : opening stock of wip 50 50
Less : closing stock of wip 60 60
Cost of production 825 840
Add : opening stock of wip 90 90
Less : closing stock of wip 95 95
Cost of goods sold 820 835
Interest 0 0
Sub total (B) 820 835
Operating income (A-B) 180 165
Add : non operating income 0 0
Less : non operating 0 0
expenses
Profit before tax 180 165
Tax 54 33
Net profit 126 132
In the above case, the first company has actually incurred less expense on labour and other
direct expenses. The remaining expenses are all same. Clearly the first company is more
efficient than the second company. Yet when you see net profit, it seems as if the second
company has done better. The second company’s better performance here is once again due
to lower tax – not because the CEO of the second company was more efficient.
So net profit is not really a great parameter when it comes to comparing operating
performance and efficiency. So let us leave the tax part and compare the profit before tax.
Even here, we have a problem. Profit before tax is arrived at after taking into account non
operating income and non operating expenses. Take the following two cases where all items
are same except non operating income.
Company paying regular tax Company paying concessional
at 30% tax at 20%
Sales (A) 1000 1000

Raw material 600 600

Labour 150 150
Other direct expenses 100 100
Add : opening stock of 50 50
wip
Less : closing stock of 60 60
wip
Cost of production 840 840
Add : opening stock of 90 90
wip
Less : closing stock of 95 95
wip
Cost of goods sold 835 835
Interest 0 0
Sub total (B) 835 835
Operating income (A-B) 165 165
Add : non operating 25 0
income
Less : non operating 0 0
expenses
Profit before tax 180 165
Tax 54 49.5
Net profit 126 115.5
In the above case, the first company has a higher profit before tax but that is only because it
has non-operating income of 25. Otherwise, the two companies are similar in all aspects. So
we have to leave even that part and go even back. Maybe operating income is the right
measure to compare two companies but what about interest? See the following case where
the companies differ only in respect of interest cost.
Company paying regular tax Company paying concessional
at 30% tax at 20%
Sales (A) 1000 1000

Raw material 600 600

Labour 150 150
Other direct expenses 100 100
Add : opening stock of 50 50
wip
Less : closing stock of 60 60
wip
Cost of production 840 840
Add : opening stock of 90 90
wip
Less : closing stock of 95 95
wip
Cost of goods sold 835 835
Interest 0 20
Sub total (B) 835 855
Operating income (A-B) 165 145
Add : non operating 0 0
income
Less : non operating 0 0
expenses
Profit before tax 165 145
Tax 49.5 43.5
Net profit 115.5 101.5

In the above case, the second company has lower operating profit but it is only because it
has interest expense of 20. Otherwise, the two companies are similar in all aspects. Once
again let us assume you are the promoter of both these companies and you want to decide
which CEO has performed better. The CEOs are in charge of only day to day operations.
You look after the financing part. It was you who took the decision that loan is to be taken
for the second company. Can you use operating profit as a measure for comparing the
performance of the two CEOs. If that is the case, the first company seems to have done
better. But take out that interest expense of the second company and both the companies are
similar in all aspects.
So remember this point. When you want to compare two companies of a same industry in
respect to operational performance, do not use net profit or operating profit. Use gross
profit. Gross profit does not take into account interest, tax, non operating income/expenses.
It measures the profit at the operational level i.e. only those expenses that relate to core
operations such as raw material, labour, repairs, etc.
Instead of gross profit some prefer to use PBDIT (profit before depreciation, interest and tax)
as a measure of operational efficiency. You may use PBDIT also.PBDIT can be used as a
measure of managerial efficiency.
Gross profit margin can be compared with similar companies in that industry to ascertain
operational performance. You should also compare gross profit margin of the company over
the past 2-3 years and see the trend and dig deep if the margin in declining.
Operating profit margin can also be compared with industry average to have an idea about
the relative performance. You should also compare operating profit margin of the company
over the past 2-3 years and see the trend and dig deep if the margin in declining. A company
should always make operating profit. It is not enough if a company makes net profit. It is
very much possible for a company to incur operating loss but post net profit. This can
happen if there is substantial non-operating income. This is not an ideal situation because
non-operating income is a one time income or income that is not from the core activity of the
company. The second item your eyes should go to while seeing a Profit and Loss account is
not the net profit but operating profit (the first item your eyes should go to is obviously the
sales figure). Remember that when companies incur loss or the profit is lower than expected
figure, they sometimes boost it by employing one-time income. The problem with this
technique is that one-time income is not sustainable. Next year, investors will expect a
higher profit than previous year and in then the one-time income route may not work out.
Even if the company again uses one-time income in next year also, it is a practice analyst
should ignore. Profit earned from such non-operating activities will ultimately die down at
some stage. So operating profit is what you should look for.

Visit creditappraisal.in

There is one more profitability measure that is widely used in western countries. It is profit
per employee. You would observe that this measure is not used a lot in India. Even though it
is mentioned in the analysis reports, it is not given enough importance. However profit per
employee is considered by many to be as important as ROIC (return on invested capital).
McKinsey Quarterly has an insightful article on this ratio. The link to the file is available on
www.creditappraisal.in under Articles tab.