Money Talk: Profit Margin Analysis is Critical when Sales Increase OR Decrease

Profit Margin Analysis uses percentage calculations to provide comprehensive measures of a company's profitability on a historical basis (typically 3-5 years) and in comparison to peer companies and industry benchmarks such as the Printing Industries of America Ratios available to you.

Objectives of Profit Margin Analysis

The objective of margin analysis is to detect consistency or positive/negative trends in a company's earnings. To a large degree, it is the quality and growth of a company's earnings that drive its value. Profit does not “naturally” follow sales. Actually, profit margin can decrease with sales growth or increase with a drop in sales.

When Sales Grow

Some of our most prudent clients, ask us to monitor their profit margins on a continuous basis so that profit growth can be strategically planned to coincide with sales growth.  Strategic growth is always recommended. When properly managed, company profits can grow with sales. Alternately, when there is an inability to strike profits at increased sales levels, companies can go out of business.

When Sales Drops

Alternately, if sales drop, we step in to help minimize the effect on profit and set an order of priority for change if needed. Good examples of this were seen throughout the recession. Many companies that lost sales became leaner more profitable entities. As the economy improves, we urge them to grow strategically with a close eye on profit.

As a manufacturer in a “mature” industry, management must recognize that costs must be monitored in order to ensure a strong profit through the simple formula below of: Sales minus Costs are equal to Profit.

Profit Margin Management

Four profit margins can be extracted from the Income Statement:  gross profit, operation profit, pretax profit and net profit. Basically, it is the amount of profit (at the gross, operating, pretax or net income level) generated by the company as a percent of the sales generated.

Formulas:

Gross Profit Margin =  Gross Profit

Net Sales (Revenue)

Operating Profit Margin =  Operating Profit

Net Sales (Revenue)

Pretax Profit Margin       =             Pretax Profit

Net Sales (Revenue)

Net Profit Margin             =             Net Income

Net Sales (Revenue)

Margins help Keep Score

The absolute numbers in the income statement are important  in our profit analysis bit have limited value, which is why we must look to margin analysis to discern a company's true profitability. Measured over time, these ratios help keep score of management's ability to manage costs and expenses and then generate profits. The success, or lack thereof, of this important management function is what determines a company's profitability. A large growth in sales will do little for a company's earnings if costs and expenses grow disproportionately at a higher rate. 

Let's look at each of the profit margin ratios individually:

Gross Profit Margin - A company's cost of sales, or cost of goods sold, represents the expense related to labor, raw materials and manufacturing overhead involved in its production process. This expense is deducted from the company's net sales/revenue, which results in a company's gross profit. The gross profit margin is used to analyze how efficiently a company is using its raw materials, labor and manufacturing-related fixed assets to generate profits. A higher margin percentage is a favorable profit indicator.

What we have seen is that when sales growth occurs, management should expect gross margin to increase, and when sales decrease, gross margin will decrease.  What we want to see is when sales growth occurs, gross profits increase, and when sales decrease, management restructures the business to keep costs in line and work to minimize the a drop in gross profit margin.

External forces can also have a substantial effect on raw material costs, particularly as these relate to the stability or lack thereof, which in turn has a major effect on a company's gross margin. Generally, management cannot exercise complete control over such costs so it is important to look at other indicators.

Operating Profit Margin - By subtracting selling, general and administrative or operating, expenses from a company's gross profit number, we get operating income.

Management has much more control over operating expenses than its cost of sales outlays. Positive and negative trends in this ratio are, for the most part, directly attributable to management decisions.

It is noteworthy to mention, that in cases of acquisition, buyers/investors will scrutinize the operating profit margin carefully.  A company's operating income figure is often the preferred metric (deemed to be more reliable) of investment analysts, versus its net income figure, for making inter-company comparisons and financial projections.

Pretax Profit Margin – When a company has access to a variety of tax-management techniques, it can allow it to manipulate the timing and magnitude of its taxable income. Hence another ratio some analysts like to use is pretax profit margin, taking the tax out of the equation. 

Net Profit Margin - Often referred to simply as a company's profit margin, the so-called bottom line is the most often mentioned when discussing a company's profitability. It is calculated as net income divided by revenues, or net profits divided by sales. It measures how much out of every dollar of sales a company actually keeps in earnings. While undeniably an important number, one can easily see from a complete profit margin analysis that it is prudent to look at several margins to analyze profitability, not just Net Profit Margin.

Usefulness of Profit Margin Analysis

Profit margin analysis is very useful when comparing companies in similar industries. A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. Profit margins are displayed as percentages; for example a 20% net profit margin means the company has a net income of $0.20 for each dollar of sales.

Once margins are established, compare results historically to manage internal progress as well as with industry peers to make sure are navigating for competitive stamina.

Printing Industries of America’s Role to Help

Printing Industries of America and your local print associations pro-actively conduct a nationwide survey of information on the income statements of hundreds of companies annually.  Anonymous results are published in The Ratios.  With participation, companies can get a volume of the results for free.  It is an excellent tool for analyzing competitive stamina and will help facilitate management’s ability to increase profits.

Margolis Partners has long been recognized as the financial expert for family-owned businesses with a specialty in the printing, packaging and allied graphic communications industries, assisting thousands of companies with strategic and financial management, valuation, mergers/acquisitions, accounting, audit and tax services.  The firm is noted for its expertise in enabling companies to optimize profits.  Proudly, it is the purveyor of the industry’s Value-Added Principles of Management, and compiles the annual Printing Industries of America Ratios, the printing industry’s premier financial benchmarking tool. 

About the Printing Industries of America Ratios Study

For more than 90 years, the Ratios program has been the leading financial benchmarking tool for the printing industry. To participate go to www.printing.org/ratios.