Subject 8. Analysis of the Income Statement

Common-Size Analysis of the Income Statement

This topic will be discussed in detail in Reading 26 [Financial Analysis Techniques].

Income Statement Ratios

The following operating profitability ratios measure the rates of profit on sales (profit margins).

  • Net Profit Margin shows how much profit is generated on every dollar of sales.

    Net income is earnings after tax but before dividends (EBIT - interest - taxes). It should be based on earnings from the company's continuing operation because the analysis is to forecast the company's future performance. Thus analysts should not consider earnings from discontinued operations, gains or losses from the sale of discontinued operations, and non-recurring income or expenses.

  • Gross Profit Margin equals percent of sales available after deducting cost of goods sold.

    This percentage is available to cover selling, general and administrative costs, and also earn a profit. It indicates the basic cost structure of a company and shows the company's cost-price position. Comparing this ratio with the industry average over time shows the company's relative profitability within the industry.

    • A declining gross profit may indicate increasing costs of production or declining prices.
    • The ratio can be affected by changes in the company's product mix: a change toward items with higher (lower) margin raises (reduces) the gross profit margin.
    • A small change in gross profit can result in a much larger change in profit margin if the company has high fixed costs.

User Contributed Comments 10

You need to log in first to add your comment.
kaleem: common size ratios are useful in analysing debt equity ratio
SaeedAlam: "A small change in gross profit can result in a much larger change in profit margin if the company has high fixed costs."

I can't figure this out...
nayagan: Should "net profit" used in net profit margin include preferred dividends?
miliee84: I agree with Saeed. Can someone please explain what it means?
jpducros: Nayahan, the text above says the net income is earning after tax but before dividends, but they mean dividend paid. Concerning dividend received, be them preferred or not, I would think they are included. TBC...
moneyguy: @nayagan- I would say no. Preferred Div are only deducted from net income to calculate EPS.
CFAToad: Preferred dividends are subtracted from Net Income. Net income only includes income owed to common shareholders. I think of preferred dividends as a debt payment, as it is not optional.
CFAToad: For more clarity. refer back to g and h. When a convertible preferred share is exercised, the numerator increases by amount of the preferred dividends that would have been owed. So the numerator becomes NI- dividends + preferred dividends.
sshetty2: I agree with above comments I don't understand the last item about larger change in profit margin with high fixed costs. I think they mean more significant change in profit margin..
akhlo: For those that are confused about the last point re change in gross profit resulting in larger change in net profit margin: If revenue = 100, COGS = 50, G&A = 40, no tax, NI would be 10, hence net profit margin is 10% and gross profit margin is 50%. Say if gross profit margin decrease by 10% to 40% (meaning revenue minus COGS = 40), G&A stays the same, no tax, then NI will become 0. Gross profit margin decreased by 10% but net profit margin decreased by 100%. Hope this helps.