When you are looking to invest in individual stocks, it makes sense to look at the company’s financial statements (or at least the company profiles on Yahoo! Finance and Morningstar). This series “Looking at Company Financial Statements and Ratios” tries to break down some of the things you should look at to help understand how the company is doing and whether it is priced fairly.
Gross margins, profit margins and operating margins are all income statement ratios. They compare a company’s revenues to their expenses. Since higher ratios indicate that a company is generating more revenue relative to its expenses, higher ratios and rising ratios are better than lower ratios or declining ratios.
The gross profit margin refers to the percentage of money that is left from the revenues after the cost of sales (which is the cost of the merchandise the company is selling). So, at the end of the 2015 fiscal year, target had a 29.4% gross profit margin, or 29 cents left for each dollar of merchandise customers spent. Walmart had a gross profit margin of 24.8%, or 25 cents left for each dollar customer spent. So, it looks like Target is doing pretty good, because they are paying less for their inventory relative to what they are selling it for. But then you notice that Target’s gross profit ratio has been declining in the last three years while Walmart is holding steady. Also, because Walmart’s sales are 7 times Target’s, Walmart’s gross margin is 5 times Target’s even though their gross profit percentage is lower. Service companies may not have Cost of Goods sold, so therefore may not have a gross profit margin; and a good gross profit margin is highly dependent on what type of industry a company is in.
The operating margin refers to the percentage that is left from the revenues after the cost of operating expenses has been taken out. It will also include the cost of goods sold, so an operating margin will always be smaller than a gross margin. Operating expenses are the expenses that a company spends to keep its operations going. It includes things like salaries, administrative activities, rent, and advertising costs. Again, you see that Target has a slightly higher operating margin at 6.2% than Walmart’s 5.6%, but they are both essentially keeping 6 cents for each dollar of revenue. Also, again, even with a lower operating profit, Walmart is generating considerably more money and Target’s margin (and operating profit amount) is on a downward trend.
The profit margin, or net margin, is the percentage that is left after all income and expenses have been accounted for, and will usually (but not always) be smaller than the operating margin. Nonoperating activity includes expenses include loan interest, taxes, and losses from discontinued operations, but also can include investment income not related to operations and gains from discontinued operations . Target is not only showed a negative trend in their profit margin, but also a negative profit for their 2015 fiscal year. Looking at the financials, this is largely because they took a $4 billion loss from discontinued operations, as they discontinued their Canadian operation. This is important to note, because it won’t be continuing, but even adjusting for the Canadian exit they still showed a declining (though not negative) profit margin. Walmart has been relatively consistent over the last three years, meaning that even though they have maintained their ability to control their costs relative to their expenses.
Why should you care?
A company’s financial performance basically breaks down to two components: What did they make, and what did they spend. By examining gross margins, operating margins and profit margins, we can see where the company’s money is going, how well it is controlling costs, and how sustainable are any profits (or losses). This makes these ratios a good point of comparison when looking at 2 similar companies, or to looking at a company compared to its industry averages, but it is only a starting point for analysis, and needs to be understood in terms of the overall industry. There are many other considerations in looking at companies that were not covered in this article, such as cash flows, leverage ratios, and price ratios, that will be covered in later posts.
This article is for information purposes only. Target and Walmart were picked to illustrate gross margins, profit margins and operating margins, but there is no recommendation of either company’s stock intended. Past performance does not determine future performance, and an investor interested in any company’s stock should proceed with caution and do lots of research before putting their money in any investment.
References and Further Reading
Financial Ratio Analysis-from My Accounting Course.com
Income Statement Analysis-from the Investing for Beginners on About.com