Profit margin calculations can be used to assess profitability, but profits can be altered dramatically by simply changing the accounting treatment of items such as depreciation and amortisation. The reliability and transparency of profits therefore diminishes as you move further down the profit and loss account or income statement. Even at the gross profit level, different businesses may use different accounting policies for the timing of the recognition of revenues and also for the value of the cost of sales attached to those revenues. The business plan should be drawn up in such a way that the accounting policies are clear and their implications fully understood.
Gross profit margin
The gross profit margin is defined as follows:
Gross profit margin =gross profit
× 100%
sales
A business must make sufficient gross margin to cover its operating costs if it is to make a profit at the operating level. Gross margins vary dramatically from industry to industry. In the software and publishing industries, for example, gross profit margins can be extremely high, possibly in excess of 90%. This is because there are high sunk costs involved in creating a new software package or magazine but, once produced, the actual cost of each incremental unit of sales is extremely low. In other sectors, gross margins may be much lower because of the high cost of manufacture but the business may have a very low operating cost base.
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A set of ratios has been calculated for Newco Corp. These can be examined by selecting main menu➞ financial results➞ ratios. The ratio sheet is shown in Chart 17.1.
Chart 17.1 Financial ratios
For Newco, the gross profit margin in year 1 was 59.5% (from the profit and loss account, E17÷ E11× 100 =59.5%). Over the forecast period the margin falls to 53.6% in year 10, because reductions in the prices charged to customers fall faster than the purchase cost of zappers. However, by lowering the selling price to promote mass-market appeal for widgets at the expense of gross margins, the business is able to exploit economies of scale, which result in a significant improvement in margins at the operating level.
Operating profit margin
The operating profit margin is defined as follows:
Operating profit margin =operating profit
× 100%
sales
The operating profit margin measures overall profitability after taking into account all operating costs: variable costs of sales and fixed or overhead costs. The business must be profitable at the operating level in order to cover the depreciation and amortisation charged for assets it employs as well as any financing charges.
Operating margins, which are often called ebitda(earnings before interest, taxes, depreciation and amortisation) margins, are regularly used as the basis of interbusiness comparisons and for the purposes of valuation. Valuations based on ebitdaare discussed in Chapter 18. Operating margins are a popular choice for comparisons as they are less susceptible to differences in accounting policies.
Newco makes a loss during the first three years of operation because it is not achieving economies of scale. The company needs an office and an accounting department whether it sells one or 1m widgets. As the business grows, the costs of the office and accounting departments can be spread over a greater volume of sales, leading to economies of scale and improvements in operating margins.
Newco becomes profitable at the operating level in year 4. Operating margins grow until they reach a peak of 37.1% in year 6 (from the profit and loss account, J31÷ J11× 100 = 37.1%). After this period margins start to erode as growth in the market slows and increased competition from Widgets Online forces Newco Corp to make further reductions in its selling price to customers.
Profit before tax margin
The profit before tax (pbt) margin is defined as follows:
PBT margin =profits before tax
× 100%
sales
The pbtmargin indicates the profitability of the business once all costs have been included. Interbusiness comparisons are less straightforward at the pbtlevel because of differences in accounting policies.
Newco turns profitable at the pbtlevel a year after it turnsebitdapositive. Although the business is profitable at the pbtlevel in year 4, it is interesting to note that it is not until year 5 that it begins to generate cash. Towards the end of the forecast period the business reaches a steady state and pbtmargins remain around the 26% level with a slight upward trend. You can perform a pbtmargin calculation yourself to verify the result.
Earnings per share
Earning per share (eps) is defined as:
EPS = profits after tax
weighted average number of shares in issue
Earnings examine the profits that are available for distribution to shareholders and are a basis for valuation based on price/earnings (p/e) ratios, which are discussed in Chapter 18.
Investors look closely atp/eratios and the growth in eps. It is from epsthat a business can pay dividends.
Newco has positive epsin year 5 of $0.04 (from the profit and loss account, I46÷ ((I39 + I42)÷ 2) from the financing sheet) and this grows dramatically over the next two years before it settles towards a steady state of around $0.5.
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