Read profitability without being misled

Profit margins help you understand how much of each sales dollar survives different categories of costs. The most useful insights often come from comparing trends over time and against similar businesses.

Gross margin

Gross margin = (Revenue − Cost of goods sold) ÷ Revenue × 100

Suppose a fictional company reports:

The company retains 35 cents of gross profit from each dollar of revenue before paying other expenses. That might be excellent for one industry and ordinary for another. A service business, retailer and heavy manufacturer should not be judged against the same gross-margin target.

Operating margin

Operating expenses include items such as administration, selling costs and depreciation. If those expenses total $2 million, the company has $1.5 million in operating profit, or a 15% operating margin.

Operating margin gives a broader view of profitability than gross margin, although accounting classification differences can complicate comparisons.

Net margin

After interest, tax and other relevant items, assume the company retains $900,000 in net profit. Its net margin is 9%. A strong net margin can be encouraging, but it does not by itself establish financial strength or an attractive share valuation.

Figure 1How much of each sales dollar survives

Revenue100%

Gross margin35%

Operating margin15%

Net margin9%

What a five-year trend might reveal

Imagine revenue increased every year but gross margin fell from 40% to 35%, while operating costs rose faster than sales. The company is growing, yet its competitive position or cost control may be weakening. Alternatively, changes in product mix or a deliberate move into a lower-margin market might explain the trend.

Figure 2Growing sales can hide a falling margin

Gross margin (%)Year

Growing sales can hide a falling margin data

Year	Gross margin (%)
Year 1	40
Year 5	35

Check for irregular gains or losses. A company may report attractive net earnings because it sold property or recorded a tax benefit. Such events should not automatically be treated as recurring operating performance.

An important caution about research and development

Research spending is not inherently a weakness. In technology, pharmaceuticals and specialist engineering, continued investment can be necessary to sustain a competitive advantage. Assess whether that spending produces lasting economic returns before considering whether to cut it.

Pricing power shows up in margins

One of the clearest signs of a strong business is its ability to raise prices when its own costs rise. Margins reveal this over time. If raw material, wage or energy costs increase across an industry and a company’s gross margin holds steady, it has probably passed those costs on to customers. If its margin falls while competitors’ margins hold, it may lack the pricing power others have.

For the imaginary manufacturers from Chapter 1, a rise in steel prices would test both. Harbour Fasteners, selling standard bolts in a competitive market, might struggle to pass the increase on quickly and see its gross margin squeezed. Precision Seal Systems, whose customers face high switching costs, might be able to raise prices with less resistance. Looking at the years in which input costs rose sharply is often more informative than looking at average years, because it shows how each business behaves under pressure.

Operating leverage: why profit moves faster than sales

Some costs rise and fall with sales, such as materials. Others stay roughly fixed whatever the sales level, such as rent, salaries and depreciation. A business with a high share of fixed costs has high operating leverage: its profit moves proportionally more than its revenue.

Using the fictional company above, assume its cost of goods sold is variable at 65% of revenue and its $2 million of operating expenses is fixed. Then:

Figure 3A 10% change in sales, a 23% change in operating profit

Revenue $9m$1.15m operating profit

Revenue $10m$1.5m operating profit

Revenue $11m$1.85m operating profit

A 10% change in revenue produces a 23% change in operating profit in either direction. That is welcome in good years and painful in poor ones. When a company’s profit has grown much faster than its sales, check whether operating leverage explains it, and remember that the same leverage will work in reverse if sales fall.

EBITDA and its limits

Many companies and analysts quote EBITDA: earnings before interest, tax, depreciation and amortisation. It is useful for comparing the operating performance of businesses with different financing and tax positions, and it is often used in lending agreements.

It also has serious limits. By excluding depreciation, EBITDA ignores the cost of the equipment, buildings and systems the business must eventually replace. For a capital-intensive company, that cost is real and recurring, and EBITDA can make it look far more profitable than it is. EBITDA also ignores working-capital needs and, for companies with large leases, now excludes most of the cost of rent, which sits in depreciation and interest under current lease accounting. Treat EBITDA as one view of operations, never as a measure of the cash available to shareholders. Chapter 4’s free cash flow is a better guide to that.

Look at margins by segment

When a company has several divisions, its overall margin is an average that can hide very different businesses. The segment note in the accounts usually reports revenue and profit for each segment, allowing a margin to be calculated for each.

This often changes the picture. A group margin that appears stable may combine a strong, growing division with a weak, shrinking one. A falling group margin may be caused by faster growth in a lower-margin segment rather than by deterioration anywhere. Before drawing conclusions from the overall margin, check which segment is driving it.

Check the quality of the earnings

Margins are calculated from reported profit, so they are only as reliable as the profit itself. A few quick checks help:

• Compare operating cash flow with profit over several years. Persistent profit without matching cash deserves investigation.
• Compare the growth of receivables and inventory with the growth of sales. If they grow much faster, revenue may be recognised before customers pay, or unsold stock may be building up.
• Look for changes in accounting policies or estimates, such as a longer useful life for equipment, which reduces depreciation and raises profit without any change in the business.
• Note recurring “one-off” items, as described in Chapter 2.

None of these proves a problem. Each is a reason to read the relevant notes before trusting a margin trend.

High margins are not the only way to succeed

Some excellent businesses earn thin margins on very large sales volumes, turning their assets over quickly. Supermarkets and distributors often work this way. Others earn high margins on smaller volumes, with more capital tied up in each sale. Both can be good businesses; what matters is the return earned on the capital employed, which combines margin and the speed with which assets generate sales.

That is why margins are a starting point rather than a verdict. A business with a modest 5% operating margin that generates sales of several times its capital each year can earn a better return than one with a 25% margin that needs a large investment for every dollar of sales. Chapter 6 brings margin and capital together in the return on invested capital.

A worked five-year review

The five-year trend described earlier can be laid out in a simple table. These fictional figures match the example of revenue rising while gross margin falls from 40% to 35%:

Figure 4Revenue up 25%, operating profit down 6%

Operating margin

Operating margin (%)Year

Revenue up 25%, operating profit down 6% data

Year	Operating margin
1	20.0
2	19.2
3	17.4
4	16.2
5	15.0

Revenue grew by a quarter over the five years, yet operating profit in year 5 was lower than in year 1. A summary that reported only “five consecutive years of revenue growth” would be accurate and misleading at the same time. The table shows the questions to ask: why the gross margin fell each year, whether price competition or a shift in product mix was responsible, and why operating costs rose in step with sales instead of more slowly.

Judge cyclical businesses over a full cycle

Some industries move with the economy, commodity prices or construction activity. In a boom, their margins can look exceptional; in a downturn, they can fall sharply or turn into losses. Judging such a business on its best or worst year gives a distorted view.

For cyclical companies, look at margins across a full cycle, ideally including at least one downturn. The average margin over the cycle is a better guide to what the business earns than any single year. Be especially cautious when a cyclical company’s margins are at a record high and its share price appears cheap compared with its current earnings: the earnings may be at a peak that will not last.

Watch how costs are classified

Companies do not all classify costs in the same way. One company may include distribution and warehouse costs in its cost of goods sold, while another records them as operating expenses. The first will show a lower gross margin, the second a higher one, even if their businesses are identical.

Because of this, gross margins can be hard to compare between companies. Operating margin, which comes after all operating costs, is usually a fairer comparison. The accounting policy notes and the expense breakdown explain how each company classifies its costs, and they are worth checking before concluding that one company is more efficient than another.

Currency and inflation effects

A company that buys in one currency and sells in another can see its margins move with exchange rates. An importer paying suppliers in US dollars and selling in Australian dollars benefits when the Australian dollar strengthens and suffers when it weakens, regardless of how well the business is run. Companies often hedge some of this exposure, and the financial instruments note explains how much and for how long.

Inflation has similar effects. When costs rise quickly, companies that reset prices slowly, for example under fixed-price contracts, can see margins squeezed for a period before prices catch up. When reviewing a margin trend, check whether currency or inflation explains part of it before attributing the change entirely to competition or management.

Questions to ask when a margin changes

A change in margin is a signal, not an explanation. When a margin moves noticeably from one year to the next, work through a short set of questions before drawing a conclusion:

1. Did prices change? Look for comments on pricing in the results commentary and compare revenue growth with volume growth where the company reports it.
2. Did costs change? Check the expense breakdown for movements in materials, wages, energy or freight.
3. Did the mix change? A shift towards lower-margin products, customers or regions lowers the average without anything getting worse.
4. Was there an unusual item? A write-down, a restructuring charge or a gain on a sale can move a single year’s margin.
5. Did the accounting change? A new policy or a revised estimate can shift costs between years.

Usually the answer combines several of these. Writing them down, with the evidence for each, turns a single percentage into an understanding of what is happening inside the business, which is what the margin was meant to reveal in the first place.

Keep the answers with your notes from Chapter 2. When the next year’s results arrive, the earlier explanation can be tested: a margin decline blamed on a temporary cost increase should recover once the cost eases, and if it does not, the explanation needs revisiting. A short record of each explanation, and whether it proved right, also shows over time how reliable the company’s own commentary tends to be.

Key takeaway

Consistency, industry context and the sources of profit matter more than one impressive percentage.

Quick reference

• Compare gross, operating and net margins over at least five years where available.
• Investigate unusual movements and one-off gains.
• Compare businesses with genuinely similar economics.
• Confirm that profits are supported by operating cash flow.