FinAnalysis, part 4: Operating Margin

It has been a while since aP talked about ratios of importance to Financial analysis. In previous topics we talked about Gross Margin, EBIT, and ROA and ROE. All of which are important ratios in analyzing profitability of a firm.

Operating Margin in simple equation is;

= Operating Income / Revenue

Definitions
"It is a measurement of what proportion of a company's revenue is left over, before taxes and other indirect costs (such as rent, bonus, interest etc.), after paying for variable costs of production as wages, raw materials, etc. A good operating margin is needed for a company to be able to pay for its fixed costs, such as interest on debt." - wikipedia.com

"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." - investopedia.com

Implication
This ratio gives an idea of how a company generate its income from operating activities on the basis of total revenue or net income. Example: an Operating Margin of 25% means, a company generates $0.25 for every dollar of sales revenue.

As with all the ratios this is another ratio that can be used to compare revenue between different companies in the same industry.

Stock market tumbling analysis for the first week of March (excluding Friday)

As the investors worry about banks and GM stock market kept continuing its dreadful falls further bringing the countries economy as of the beginning of March. This blog post will solely provide analysis of the situation.

The area colored in red is the fall for the month of March so far, as we have yet to experience what Friday will bring on DOW Jones Industry Index.

This Chart shows the numerical changes of the first week of March. It just seems the way the economy is moving, none of the Economic bail out plans happened to design a change in the pattern. One would think with the help of Millions of dollars of tax payers money lend to Troubled Assets, they would show at least a slight improvement, which clearly was denied of the fact when AIG beg for another Bail out money.

I believe these companies required to be extensively restructured, and force extreme cautious on internal money management or some sought. It is to be given thought that US consumer base is in fact declining as far as the consumer purchases go. Consumers now expand its purchasing power only to essential items, which eliminate the possibility of economy stimulating consumer sales for companies. But I believe the Stimulus plan we talked in previous blog post, will have a good impact as to stimulate the country's economy. Because where they are getting those billion dollars to fund bail out plans, there is not going to be more of those soon or later...

FinAnalysis: OCF operating Cash flow

OCF stands for operating cash flow, simply meaning cash flow provided by operating activities of a firm.

Definitions from other sites:
Wikipedia:
"Operating cash flow = Cash generated from operations less taxation and interest paid, investment income received and less dividends paid gives rise to operating cash flows per International Financial Reporting Standards"

Investopedia:
"The cash generated from the operations of a company, generally defined as revenues less all operating expenses, but calculated through a series of adjustments to net income.

It's arguably a better measure of a business's profits than earnings because a company can show positive net earnings (on the income statement) and still not be able to pay its debts. It's cash flow that pays the bills!"

Equation:
OCF = EBIT - taxes + depreciation

Why interest not deducted in here?
Interest is considered financing expenses, and most of the time it is already included when calculating WACC.

Excel Template: WACC Calculator

In this post I am going go over WACC calculation and share with you a spreadsheet template I created to calculate WACC for a firm with given information.

WACC in other words, weighted average cost of capital. Or cost of capital in terms of weighted average calculation. Companies use debt or issue preferred stocks as a mean of generating capital for operations. WACC take into account the portions of these debt and equity financing and calculate the interest rate the company have to pay for every dollar it uses for financing activities.

This is also the rate company use as required rate of return in project management, capital budgeting, project evaluation, NPV calculations etc.

Investopedia.com says: "A calculation of a firm's cost of capital in which each category of capital is proportionately weighted. All capital sources - common stock, preferred stock, bonds and any other long-term debt - are included in a WACC calculation"

Here is a screen shot of the WACC calculator I designed.

You can download this spreadsheet free of charge and use it to calculate your required rate of return. (WACC calculator is copy right material of ashPresentom)

FinAnalysis: ROA and ROE

ROA: return on assets

ROA = Net Income/ Tot. Assets

Definitions:
1. An indicator of how profitable a company is relative to its total assets. -Investopedia.com
2. what the company can do with what it's got - wikipedia

Analyze formula:
this ratio you can find netincome per unit of total assets. Which means how much income have we generated for every unit of assets we consumed in the business or every unit of assets the business has.

Implication:
We can use this ratio to find if company/firm is efficiently using its assets to generate income.
Higher the ROA - better, more income from assets, and company using assets very efficiently to generate their income.


ROE : Return On Equity (basic form)

ROE = Net income/ Total Equity

Definition:
1. A measure of a corporation's profitability that reveals how much profit a company generates with the money shareholders have invested. -investopedia.com

Analyze ratio:
This ratio divide netincome per unit of equity.

Just like ROA this ratio tells how much income a firm generate per unit of stockholders equity money they have invested in the company. So from a stockholders perspective higher ROE mean the company is generating lot of income from their money. Which is a good thing for investor as it can generate higher return and possible divident for them.

As for the firm, higher ROE mean they are pleasing shareholders and they are using that equity money efficiently to generate income.

FinAnalysis: EBIT

EBIT - earnings before interest and tax

Meaning: amount of money left in a firm after paying operating and admin expenses, but before paying interest and income tax. Basically this is how much money firm is left with to pay their debt.

- EBIT = Operating Revenue – Operating Expenses + Non-operating Income

Definitions:

1. (EBIT) is a measure of a firm's profitability that excludes interest and income tax expenses - Bodie, Z., Kane, A. and Marcus, A. J. Essentials of Investments, McGraw Hill Irwin, 2004, p. 452.

2. operating and nonoperating profit before the deduction of interest and income taxes. - thefreedictionary.com

3. An indicator of a company's profitability, calculated as revenue minus expenses, excluding tax and interest. EBIT is also referred to as "operating earnings", "operating profit" and "operating income" - investopedia.com

EBIT/Interest

Implication:
- measure of long-term solvency, times interest earned ratio.
- How well a company have its interest covered.
eg. if company X's EBIT is $20,000 and interest expense is $10,000 the ratio is 2. Meaning they are capable of paying interest for their debt.
- with a volatile company like movie industry, ratio of 2 may not be adequate.


"Long-term Solvency" - firms long-run ability to meet obligations, or financial leverage.

FinAnalysis: Preface for Ratios

Preface of the financial ratio posts.

As financial ratios are very important in my career path, I do lot of research on each individual ratios. Source these ratios using text books to online websites.
For each ratios I try to encapsulate as much analytical decisions or trends we can use from those ratios to interpret the ratios in balance sheet and income statement.

This research will help me refer back to my finding in later times and hope this will help you with analyzing your financial reports.

Summary of the Ratios Covered so far.
1. Gross Margin
2. EBIT (Earnings before interest and tax)
3. FinAnalysis: ROA and ROE