Profitability Ratios - Operating Margin

Operating Margin is used to measure a company's pricing strategy and operating efficiency. Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt. 


Operating Margin  = Operating Income / Net Sales


Note :- Operating margin gives an idea of how much a company makes (before interest and taxes) on each rupee of sales. If a company's margin is increasing, it is earning more per rupee of sales. The higher the margin, the better. A higher operating margin means that the company has less financial risk.


Illustration :-
This is key highlights of 2nd Quarter Result 2010- 2011 declared by Reliance Industries Limited on 30 Oct 2010.

From this Highlights we have relevant information to calculate Operating Margin:-
Operating Income of Q2 FY11 = Rs. 10,068 cr.
Net Sales of Q2 FY11 = Rs. 57479 cr. (Took from the "Profitability Ratios - Gross Margin" Post)
So, Operating Margin = Operating Income / Net sales
Operating Margin = 10,068 / 57,479 = 0.17
Analysis :- 
So, Operating Margin is 0.17 means Company makes Rs. 0.17 paise (before interest and taxes) on each rupee of sales for Q2 FY11.

Profitability ratios - Gross Margin

Gross margin, gross profit margin or gross profit rate is the difference between the sales and the production costs excluding overhead, payroll, taxation, and interest payments. Gross margin can be defined as the amount of contribution to the business enterprise, after paying for direct-fixed and direct-variable unit costs, required to cover overheads (fixed commitments) and provide a buffer for unknown items. It expresses the relationship between gross profit and sales revenue. It is a measure of how well each rupee of a company's revenue is utilized to cover the costs of goods sold.


It can be expressed as :-
Gross Margin = Net Sales - Cost of Goods Sold + Annual Sales Return
Or,
Gross Margin = Gross Profit / Net Sales
Gross margin Percentage = Revenue - Cost of Goods Sold / Revenue
Note:- Companies with higher gross margins will have more money left over to spend on other business operations, such as research and development or marketing. Companies with the higher Gross Margin Percentage, the more the company retains on each rupee of sales to service its other costs and obligations.


Illustration:-
This is the 2nd Quarter Result of Reliance Industries Limited for session 2010 -2011 

From this Result, we can take the relevant information to calculate the Gross Margin :-
Gross Profit for 2nd Quarter 2010 =  Rs. 6149 cr.
Net Sales for 2nd Quarter 2010 =  Rs. 57479 cr
So, Gross Margin = Gross Profit / Net Sales
Gross Margin = 6149 / 57479 = 0.10


Analysis:-


So, Gross Margin is 0.10 means for every rupee generated in sales, the company has Rs. 0.10 paise left over to cover basic operating cost & Profit for 2nd Quarter 2010 -2011. 

Tools of Fundamental Analysis

Financial Ratios are the main tool of fundamental Analysis. It includes the following ratios :-

1. Profitability Ratio 
2. Liquidity Ratio
3. Activity Ratio or Efficiency Ratio
4. Debt Ratio
5. Market ratio

1. Profitability Ratio :- Profitability ratio measures the company's use of its assets and control of its expenses to generate an acceptable rate of return. Company's Profitability can be measure on the basis of following factors:-

• Gross Margin
• Operating Margin
• Profit Margin
• Return on Equity
• Return on Investment
• Return on Assets
• Return on Net Assets

 Liquidity Ratio :- Liquidity Ratios measures the availability of cash to pay debt. Company's liquidity can be measure on the basis of following factors :-

• Current Ratio
• Quick Ratio
• Cash Ratio 
• Operation Cash Flow Ratio

Activity Ratio :- Activity Ratio measures how quickly a firm converts non-cash assets to cash assets or measures the effectiveness of the firms use of resources. Company's effectiveness can be measure on the basis of following factors :-

• Average Collection Period
• Daily Sales Outstanding Ratio
• Assets Turnover
• Stock Turnover Ratio
• Receivables Turnover Ratio
• Cash Conversion Cycle

 Debt Ratio :- Debt ratios measure the firm's ability to repay long-term debt. Debt ratios measure financial leverage. Company's Debt Ratio can be measure on the basis of following factor :-

• Debt Ratio
• Debt to Equity Ratio

Market Ratio :- Market ratios measure investor response to owning a company's stock and also the cost of issuing stock. Company's Market factor can be measure on the basis of following factor :-

• Earning Per Share
• Payout Ratio
• P/E Ratio
• Dividend Yield 
• Price/Cash Flow Ratio
• Price to Book Value Ratio
• Price/Sales Ratio

So we saw the overview of different types of ratios which is used to measure the Company's Profitability, Liquidity, Efficiency, Debt & Market factor. From the next post we will see individually each and how these are helpful to analyze the stock fundamentally.

Factors of Fundamental Analysis

A company is to be analyzed on fundamentle basis on the basis of following factors :-

• Profitability :- Company's ability to income and sustain growth in both short-term and long-term. A company's degree of profitability is usually based on theincome statement, which reports on the company's results of operations.
• *Solvency :- Company's ability to pay its obligation to creditors and other third parties in the long-term.
• *Liquidity :- Company's ability to maintain positive cash flow, while satisfying immediate obligations.
• Stability :- Company's  ability to remain in business in the long run, without having to sustain significant losses in the conduct of its business. Assessing a company's stability requires the use of both the income statement and the balance sheet, as well as other financial and non-financial indicators.

*Both 2 and 3 are based on the company's balance sheet, which indicates the financial condition of a business as of a given point in time.

Fundamental Analysis of Stock

Fundamental analysis is a stock valuation method that uses financial and economic analysis to predict the movement of stock prices.

The fundamental information that is analyzed can include a company's financial reports, and non-financial information such as estimates of the growth of demand for competing products, industry comparisons, and economy-wide changes.

Main Strategy

To a fundamentalist, the market price of a stock tends to move towards its intrinsic value. If the intrinsic value of a stock is above the current market price, the investor would purchase the stock, and if the intrinsic value of a stock was below the market price, the investor would sell the stock.
To start a fundamentalist makes an examination of the current and future overall health of the economy as a whole. In this step you should attempt to determine the direction and level of interest rates.
After you analyzed the overall economy then analyze firms individually. You should analyze factors that give the firm a competitive advantage in its sector such as management experience, history of performance, growth potential, low cost producer, and etc.

About Fundamental Analysis

Fundamental analysis of a business involves analyzing its financial statements and health, its management and competitive advantages, and its competitors and markets. When applied to futures and forex, it focuses on the overall state of the economy, interest rates, production, earnings, and management. When analyzing a stock, futures contract, or currency using fundamental analysis there are two basic approaches one can use; bottom up analysis and top down analysis.

Fundamental analysis is performed on historical and present data, but with the goal of making financial forecasts. There are several possible objectives:

• to conduct a company stock valuation and predict its probable price evolution,
• to make a projection on its business performance,
• to evaluate its management and make internal business decisions,
• to calculate its credit risk

"Fundamental Analysis tells us which stock to choose"