3.6 Profitability Ratios

These ratios provide immediate insight into how well management is running a business.  They become especially meaningful in relation to competitors in the same industry.  Two closely watched profitability ratios are:

Gross Margin is the difference between a company's sales and cost of goods sold scaled by Sales.  The higher the gross margin usually implies the higher priced its goods and or services are.  For example, if two firms are operating at similar levels of cost efficiencies but one has a higher gross margin than the other this usually implies that the higher gross margin is either charging higher prices or dealing with non commoditized goods and services that carry a higher price tag.

Gross margin is not required under US GAAP and therefore for most public companies this is a derived number from the reported cost of goods sold.  Similarly, a firm’s Operating Margin measures the performance of the firm’s primary business(es).   This includes not only the cost of goods sold but also other costs associated with operations such as selling and general administration.

Tutor Reconciliation:  Proctor and Gamble (PG)

Our objective is to reconcile the following from the 10-K:

Step 1:  Bring up the Income Statement and Balance Sheet for Proctor and Gamble as described in section 3.2.  This was displayed at the bottom of the screen as follows:

The above items deal mainly with the income statement apart from the number of shares outstanding for expressing on a per share basis.

You can stretch across a little the column 1 as displayed above to make the labels more easily displayed and read. 

For Proctor and Gamble you can see that the Gross Margin is not directly provided but it is easily computed from the “Cost of products sold” ($37,919) as P&G describe it.  Similarly, Net Sales are $78,938 and Operating Income (EBIT) is $16,021.  Finally, the shares outstanding are provided from the Shareholders’ Equity section of the Balance Sheet.

Step 2:  Click on Calculate and we can verify the input and derived fields for the following:

Sales per Share = 27.7609 per share

Cost of Goods Sold = 13.3353 per share

EBIT (Earnings Before Interest and Taxes) = 5.6343 per share

Derived:

Gross Profit Margin (Sales – COGS)/Sales = 0.5196

Operating Profit Margin  = 0.203

In step 1 we extracted the aggregate numbers from the 10-K and so the full reconciliation can now be traced through as follows: