How to Judge Profit Performance
A business earns profit by making sales and by keeping expenses less than sales revenue, so the best place to start in analyzing profit performance is not the bottom line but the top line: sales revenue or earnings. Here are some questions to focus on:
Trends: How does sales revenue in the most recent year compare with the previous year? Higher sales should lead to higher profit, unless a company’s expenses increase at a higher rate than its sales revenue. If sales revenue is relatively flat from year to year, the business must focus on expense control to help profit, but a business can cut expenses only so far.
The real key for improving profit is improving sales. Therefore, stock analysts put first importance on tracking sales revenue year to year.
Gross margin ratio and contribution margin: What is the business’s gross margin ratio (which equals gross profit divided by sales revenue)? Even a small slip in its gross margin ratio can have disastrous consequences on the company’s bottom line. Stock analysts want to know the business’s contribution margin, which equals sales revenue minus all variable costs of sales (product cost and other variable costs of making sales).
But external income statements don’t always reveal contribution margin; financial statement readers may need to perform the calculation for themselves.
Other ratios: Based on information from a company’s most recent income statement, how do gross margin and the company’s bottom line (net income, or net earnings) compare with its top line (sales revenue)? It’s a good idea to calculate the gross margin ratio and the profit ratio (net income divided by sales revenue) for the most recent period and compare these two ratios with last period’s ratios.
If you take the time to compare these two ratios for a variety of businesses, you may be surprised at the variation from industry to industry.
One last point: Put a company’s profit performance in the context of general economic conditions. A down economy is likely to put downward pressure on a company’s profit performance, and you should allow for this in your analysis. In a growing economy, most companies should do better, of course, because a rising tide lifts all boats.