Classroom | Quantitative metrics to look for -- the key numbers (Equity: Part 13)

Any business is run with an objective to make profit. Unless there is a profit motive, there does not exist any reason to run a business. This profit can be seen as compensation for the effort taken to run the business. Additionally, this is also a compensation to the shareholder for putting his risk money (equity) in the business. To analyze the operations of a business, the profit is calculated at different stages. Multiple stage analysis helps in finding the inefficient business stage(s) and thereafter, improvements can be effected to increase the profitability at the respective stage(s).

Gross Profit/ Margin

Gross profit is the difference between sales and cost of goods sold. It reflects the dependence of any business and its sensitivity towards the movement of raw material prices. Naturally, higher the gross profit (margin), higher is the ability of a business to absorb an increase in raw material prices. By the nature of their business model, the gross profit margin for fast-moving consumer goods (Biscuits, cosmetics etc.) will be high while the same will be lower for consumer durables such as refrigerators and automobiles etc.

EBITDA

It stands for earnings before interest, depreciation, taxes and amortization. This reflects the money left from sales collection after paying for the cost of goods sold (gross profit as mentioned above) and all other operating expenses such as repairs, rent, electricity, labour cost etc. This ratio is used to compare the efficiency of operations of various companies with different sizes, structures, taxes, and depreciation within or across the industries.

EBITDA tells us how much of the revenue of the company is left to take care of depreciation, interest and taxes and then leave some money for shareholders. Ebitda can be compared across industries, to see which industry is more profitable or among peers to see which companies are more profitable. For instance, if Maruti Suzuki earns higher Ebitda margins than Tata Motors, then one can say it's more profitable and this differential could explain other aspects such as higher net margins or higher valuations.

Net profit or bottom line:

The profit growth should at least be in line with top-line growth. This is a good indication that the company is able to maintain its profit margins. If the profit growth rate is higher than the top-line growth rate, it indicates high-profit margins. This could be due to the company having better pricing power, cost efficiencies or the industry as a whole doing well. Likewise, profit growth lower than sales growth indicates weak margins. This could be due to the company not having pricing power, cost inefficiencies or the industry as a whole not doing well. Like EBITDA, net profit margins too can be compared between industries or compared to peers. For instance, the net profit margin of an FMCG company will typically be higher than that of a retail company, reflecting the differing nature of their business models.

Cash flow

Along with the growth of the business, it is important that the business keeps generating cash. For that, among other things, it should manage its working capital efficiently. Cash is king goes the saying and it's true. If a company shows net profit growth but cash flow from operations or free cash flow has declined, then it's not a good sign. How can that happen? If profit has increased and it has come on the back of more relaxed working capital norms, then cash flows can decline even when profit increases.

Say, profit in the cash flow statement has increased to Rs 100 from Rs 80 earlier. But if working capital has increased to Rs 40 from Rs 10 earlier, then the cash flow from operations will be Rs 60 (Rs 100 minus Rs 40), compared to Rs 70 (Rs 80 minus Rs 10). Thus, even with a higher profit the cash flow position has not improved.