Tuesday, 2 September 2014

Profitability (Practical Experience)

The purpose for a company to exist is to earn a Profit. A good and safe company should provide continuously stable and increased profit.

A company can improve its profits by two means: Revenue and Profit Margin. Increasing revenue means company expand its business and sells more products. Increasing profit margin means company find a way to cut down its total cost.

From my previous experiences, increasing profit caused by increasing revenue will have instant effect on share price whereas increasing profit caused by increasing profit margin will have a delay in time for its share price to increase but the increment impact will be higher.

To play safe, it is wise to set a minimum profit margin for the company you want to invest.

I usually set more than 5% profit margin (more than 10% is better). This is because investors usually will overreact if a profitable company suddenly has incurred loss. A low profit margin company such as less than 5% profit margin easily result in loss if anything happened (for example material cost increased or decrease in sales) and this will cause the share price to drop dramatically.

Different types of profit can be used to calculate profit margin. Different profit margin will tell different story about the company. If we want to calculate profit margin, the denominator with definitely be revenue. For numerator, we need to decide which profit to use. There are several profits to choose from:

1 Gross profit

2 Operating profit

3 Profit before tax

4 Net profit

Gross Profit only deducts the direct costs  involved in producing  products. Examples are materials, direct labour, factory overhead such as electricity bill and depreciation of machines.

Gross profit margin shows the maximum profit margin that a company can earn from its revenue because the costs involved are imperative costs to produce the product and cannot be cut. Gross profit of a company can only be improved  through technology advancement(use high tech machine to reduce cost per unit) or through human capital management (increase efficiency of workers) or reduce waste.

Operating Profit includes some important but flexible costs which can be cut down during crisis such as: general & administrative expenses, sales & distribution expenses, promotion expenses, research expenses.

Operating Profit represent the real profit that come from its main business(excluding gain from interest or investment)

Profit Before Tax is often used instead of Net profit to compare profit across country with different tax.

Net Profit represents the total profit that a company get during that year. It is very important because it represents the total return that shareholders can get from the company. It is the final result. However when you want to use net profit to calculate profit margin, remember to exclude profit or lose from non-recurring items or discontinued activities because it is unlikely to occur in the future.

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