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Profitability ratios are one of the important metrics for an investor to analyse before he or she invests in a company. These ratios tell an investor how efficiently a company runs its business. It is used to determine if a firm is able to generate net income with respect to the
company’s sales, operating costs, shareholder’s equity and assets for a particular period. It also tells the investors how prudent the company is making use of the money available in creating value. The profitability ratios differ depending on the sector and size of the
company. But I doubt whether these ratios apply to new-age tech companies like Zomato, Swiggy, Paytm, etc.
Firstly, we will discuss various margin ratios, which are part of the profitability ratios. Margin ratios measure a company’s competence to convert sales into profit by keeping its costs low.
Gross profit margin: To calculate this ratio, we need to know the sales/revenue/turnover and the cost of goods/services to generate those sales. If the gross margin is high, the company is able to control its cost to produce the goods or service. Higher the margin
means the company is likely to have pricing power in the market they cater to. It also tells a company has an upper hand when it comes to procurement. A consistent increase in the gross margin over a long period is good for the company as well as investors who wish to
stay invested for an extended period.
Gross profit = Sales – Cost of goods or services sold
Gross profit margin = (Gross profit / Sales) * 100
Operating profit margin: This is the next performance measure investors should look into while assessing profitability ratio. If this margin is high then the company is able to control its operating expense and vice versa.
Operating profit = Earnings Before Interest & Tax (EBIT) = Revenue – Cost of
goods/services sold – Operating Expenses
Operating Profit margin = (EBIT/Sales) * 100
EBITDA margin: This is one more way of calculating operating margin. EBITDA stands for earnings before interest, taxes, depreciation, and amortization. There is a slight difference between EBIT and EBITDA. EBIT value excludes depreciation and amortization numbers,
while EBITDA includes depreciation and amortization numbers. So, the simple way to arrive at the EBITDA value is to take the EBIT value and add it to depreciation and amortization available in the cash flow statement.
EBITDA margin = (EBITDA/Sales) * 100
Net income margin: Net income is also known as net profit or bottomline. It is the income left after taking into account all kinds of expenses including administrative expense, marketing cost, salaries, interests, taxes, etc. Net income has some disadvantages as it has
one-time gains or expenses from extraordinary items, which are known as noise. The value denoted by net income has very little to do with the firm’s actual or core business operations. Normally, we look at the profit after tax keyword in the profit and loss statement of Indian
businesses when they report results.
Net income margin = (Net income/Sales) * 100
Operating Cash flow margin: Cash flow is an important measure that should be analysed long with net profit. There are three sources from which a firm receives cash. They are cash from operating activities, cash from investing activities and cash from financing activities. Anyway, for calculating cash flow margin, we will be focusing on cash flow from operating activities as the other two are not part of the company’s core operations. It measures operating cash flow as a percentage of sales. It is important for a company to maintain positive cash flow, so that they are able to make payments to their suppliers, pay interests, dividends, salaries, etc. If a company has negative cash flow, then it will be forced to borrow more from banks and other financial institutions to continue its operation and thereby, affecting the smooth functioning of its operations.
Operating cash flow margin = (Operating cash flow/Sales) * 100