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How to Calculate Sales-Related Profitability Ratios?
Profit can be measured in a number of ways. For example, Gross Profit is the profit that is the difference between the manufacturing cost of goods sold and sales. This is called Earnings Before Interest, Depreciation, Taxes, and Interests Amortization (EBIDTA) by many firms. However, many other companies calculate net income or Profit After Tax (PAT). As taxes cannot be controlled, to negate their influence Profit Before Tax (PBT) is calculated.
Investors, however, use operating profit or Earnings Before Interest and Taxes (EBIT) as a measure of profitability. Moreover, on an after-tax basis, Net Operating Profit After Tax (NOPAT) is also calculated by investors.
Types of Sales-Related Profitability Ratio
On broader terms, the sales-related profitability ratios can be categorized into the following four categories −
Gross Profit Margin
The Gross Profit Margin or Gross Margin Ratio is calculated by dividing gross profit by sales.
$$\mathrm{\mathrm{Gross\: Profit\: Margin}\:=\:\frac{\mathrm{\left ( Sales\: - Cost\: of\: Goods\: Sold \right )}}{\mathrm{Sales}}\:=\:\frac{\mathrm{Gross\: Profit}}{\mathrm{Sales}}}$$
The Gross Profit margin shows the efficiency of a company in producing each unit of a product. The Cost of Goods Sold is achieved when the gross profit margin is subtracted from 100.
The gross profit margin may increase if −
Prices go higher when COGS is constant.
Low COGS, cost price remaining constant.
Variations in sales prices and costs, with widening margin, and
Increase in volume of higher profit margins.
Net Profit Margin
When operating expenses, interests, and taxes are deducted from gross profit, net profit is obtained.
The net profit margin ratio is given as profit after tax divided by sales −
$$\mathrm{\mathrm{Net\: Profit\: Margin}\:=\:\frac{\mathrm{PAT}}{\mathrm{Sales}}}$$
This ratio establishes the relationship between net profit and sales. The value of the ratio shows the efficiency of the management in the manufacture, administration, and sales of the products. This ratio also shows a company’s capacity to withstand tough economic conditions. Companies which have higher net profit margins can keep producing products at a lower rate during fragile economic situations. They can also withstand higher production costs and declining demand for the products.
To get a clear picture of the condition of profitability, considerations of Gross Profit Margin and Net Profit Margin together may prove to be further accurate.
Net Operating Profit After Tax Margin (NOPAT Margin)
In most cases, the PAT is calculated excluding the interest in borrowings. However, a company gets a tax shield when it pays higher taxes. The tax shield is a substantial measure of taxes and in the case of larger firms, it cannot be ignored. Therefore, to rectify the value and significance of Net Profit Margin, NOPAT Margin is used.
$$\mathrm{\mathrm{NOPAT\: Margin}\:=\:\frac{\mathrm{NOPAT}}{\mathrm{Sales}}}$$
NOPAT Margin offers a clearer picture of the operating performances of companies. It reduced the errors that the net profit margin holds due to ignoring the tax shield offered by the interest paid by the company.
Operating Expenses Ratio
It shows the changes in the profit margin. That is why it is also called changes in the profit margin ratio. It is arrived by dividing Operating Expenses by Sales.
$$\mathrm{\mathrm{Operating\: Expenses\: Ratio}\:=\:\frac{\mathrm{Operating \: Expenses}}{\mathrm{Sales}}}$$
Unlike other profitability ratios, a higher operating expenses ratio is detrimental for a company. An increase in operating expenses ratio would mean that the company has a small amount of income to meet its obligations, such as interests and dividends. To get an idea of the behavior of the operating expenses ratio, historical and present values of the ratio must be analyzed.
Conclusion
There may be discretionary changes in a company due to management policies. Therefore, a detailed study on year-to-year variations is necessary. Variations in the operating expenses ratio may also occur due to changes in administering and selling expenses, and changes in sales price among many other factors.
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