My name is Steve Chen, a fellow member of ACCA and course director at APC (www.globalapc.com), teaching ACCA online courses to students from all around the world.
Accounting students may have studied many ratios in analysing the company’s performance. When I was teaching ACCA Financial Reporting in a few years ago, one of my classroom students asked me a question and surprised me.
‘Steve, I think profitability ratio does not matter for a business. However, liquidity and gearing ratios matter as these ratios can be used to assess whether the company’s position is safe. Therefore, the value of the company derives from liquidity and gearing ratios’.
I must admit that liquidity and gearing ratios are essential to analyse whether a business is safe. However, the business share price may be primarily affected by profitability ratios rather than the other two in many cases.
Calculation: Gross profit x 100%
This is the profit of the sale of the product or rendering of service, before considering any administrative, interest and tax expenses. Here are some ways that the gross margin ratio could be improved:
Increase the selling price. However, a business must consider the potential implications for product sales if the customers are price sensitive. This means that if the price is high, this may lead to a reduction in sales volume, and hence the total sales revenue would reduce.
Reduce costs of sales by reducing the materials costs, labour costs and other production overhead such as rent expense. However, such a reduction may lower product quality, and may lead to a further reduction in sales revenue.
Reduce stock wastage. Stock waste is common in supermarkets, for instance, deli food wastage. Improving ways to manage stocks could result in fewer inventory write-offs and an increase in gross margin.
Offer bonus payments to employees. This could improve the sales revenue because more units may be sold by sales staff, given that they feel motivated by the bonus payment.
Changing the sales strategy. Businesses may change the sales mix of their existing products or strategies. For instance, some businesses may have loss-making products to attract customers, and after the customer has bought those products, higher margin products could also be sold to improve the gross margin. An example of this is Fiverr (https://www.fiverr.com/) where lots of freelancers offer their services at a super low price aiming to attract long term, higher margin customers.
Reduce the number of unprofitable customers. Some customers may be corporate customers; for instance, they usually buy products in a larger volume than individuals. Some of these may not pay on time, or haggle for a very good price, and effectively, they are reducing the business’s normal selling price considerably. Cutting the number of these customers could potentially improve gross margin.
Improve information systems. For instance, for many car agencies or real estate companies’ vehicle or property holdings information is updated quite frequently, enabling them to see the stock information regarding their cars and houses. By monitoring these closely, companies can turn those stocks more quickly into profit.
The gross margin of the company needs to be compared with other companies in the same industry to determine whether the company is performing well or not. Gross margin in service industry businesses such as accountancy and legal firms tend to be higher than those in capital-intensive companies. Gross margins of different industries can also be compared, enabling the investors to see which industry is more attractive to them. A useful website for comparing the ratios of different industries is https://csimarket.com.
Calculation: Operating profit x 100%
This is the profit ratio after considering all inventory costs and administrative costs but before interest and tax paid. Operating profit is sometimes referred to as profits before interest and tax (PBIT) or earnings before interest and tax (EBIT).
The operating margin could be improved in the following ways:
The above ways to improve gross margin could also improve operating margin.
Reduce the number of dealers. For instance, cutting the number of agents selling products on our behalf could potentially reduce the commission paid and, therefore, marketing and distribution overhead. However, the downside of this is that total sales revenue may be affected, particularly for those industries where customers would usually buy products from dealers or agents rather than from the manufacturer. Examples of these include car industry and fast moving consumer goods (FMCG) sector companies.
Reducing management remuneration. However, a lower quality management team may be recruited, and this may end up adversely affecting the business’s long-term growth.
Outsource certain functions. Many large businesses nowadays such as Huawei and Citibank have set up finance-shared service centres, cutting the management costs of not having separate finance departments in each group company, i.e., there is only one centralised, shared, service centre working for all companies in the same group.
Calculation: EBITDA x 100%
Many large businesses nowadays calculate ‘EBITDA margin’ or Earnings Before Interest, Tax, Depreciation and Amortisation. This is to add back depreciation and amortisation expenses to the earnings before interest and tax.
It is slightly different from the operating margin because this measure enables investors to compare the profitability of different companies. Different companies may calculate depreciation or amortisation expenses using different methods. By excluding these elements, profitability is not easily distorted by methodologies.
Calculation: Earnings before tax x 100%
The operating margin of some businesses may be high but their pretax margin low. The difference between these two is that the pretax margin also includes the interest expense element in the calculation. Some businesses may rely heavily on debt finance to operate their businesses, and therefore, they tend to pay higher interest expense compared to others, leading to a lower pretax margin ratio.
Net Profit Margin:
Calculation: Profit after tax x 100%
This ratio measures the profit after considering all expenses in a business. The pretax margin excludes tax expenses. However, the net profit margin includes tax expenses. Tax expenses in different companies are different because of varying tax rules applied to the treatment of disallowable expenses and tax-exempted income.
Investors’ websites, agencies, and magazines may calculate and mark company’s ratios as a TTM (Trailing 12 Months: for one year), 5YA (on average for the past five years), 3YA (on average for the past three years) or on a quarterly basis.
Vertical and Horizontal Analysis:
The above profitability ratios (gross margin, operating margin, EBITDA margin, pretax margin and net profit margin) are in percentage terms (%). The method to calculate these ratios is called vertical analysis, i.e., dividing profits (bottom figure) into sales revenue (top figure).
Another method of presenting these ratios is to use trend or horizontal analysis. This means to calculate the changes of these profit margins over time. For instance, the gross margin was 25% in year 1 and 28% in year 2, so the gross margin has increased by 3% from year 1 to year 2.
In addition to providing ACCA lectures online, I also wrote articles in ACCA AB magazine. Besides, I am the author of four accounting books. If you are interested in studying ACCA courses with me, please visit my website http://www.globalapc.com for further information, where you can find many of my ACCA demo video lectures.