Net Margin

The second readily available indicator is the net margin, the comparison between sales and profits. Compute by dividing net profit by total sales; the result is expressed as a percentage. This formula is summarized in Figure 2.2.

FIGURE 2.2 Net Margin

With any formula, you need to ensure that you use the correct figure. Otherwise, comparisons will not be valid. In the case of net profit, you may ran into problems because three different versions of net profit may be found on the financial statement.

The first is operating profit, which is simply the result of subtracting the "cost of sales," and "selling, general, and administrative expenses" from total sales. The result is the profit produced from selling the company's products or services. It does not include income or expenses not directly related to the sale of the product or service, and also excludes income taxes.

Second is the net profit before taxes, which includes all forms of income and expense, whether or not directly related to the production of sales. These may include income or loss from foreign exchange, interest income and expense, and other nonoperational adjustments.

Third is the net profit (or net profit after taxes), meaning the profit after including all income and deducting all costs and expenses. This is the final number that should be used for calculation of net margin. It is consistent, and it allows for all items, including those items not directly related to operations of the corporation.

Net margin is one of those comparative features of financial analysis that should be steady and consistent. The more consistent, the better. A dependable, consistent net margin, year after year, is a sign of a well-managed corporation. If management is able to maintain that level even when sales are growing over time, it is a positive indicator. Too often, analysts and investors come to expect all factors to improve from year to year. Just as sales are expected to rise, so are net profits and the net margin. This is not realistic. You cannot expect net profits to grow at a greater rate than other financial factors. There is such an unavoidable relationship between sales and costs that net profits will not exceed the yield range on a consistent basis. To expect that to occur ignores the realities and economics of corporate and competitive life.

KEY POINT

Don't fall into the trap of expecting yields to rise every year. A more valuable sign is the ability of a corporation's management to produce acceptable yield levels consistently year after year.