Operating profitability and working capital

Which profit measure should you use?

Memorize

Analysts measure profit at three levels, each usually expressed as a margin, income as a percentage of revenue. Companies use them loosely; a careful analysis does not.

Measure	What it includes	Strength	Weakness
Net income, net margin	everything: operating, financing and investing results and taxes	the most complete measure of what is left for shareholders	hard to compare across firms or years: capital structure, capital spending and one-off items distort it; less useful for early-stage or cyclical firms with losses
Operating income, operating margin	the core business, before financing costs, taxes and non-recurring items	comparable across firms and over time; negative less often than net income	depreciation and amortization (D&A) reflect investment policy: a firm that underinvests shows a higher margin for now
EBITDA, EBITDA margin	operating profit before D&A, a measure before discretionary spending	compares firms with different leverage, taxes and investment policies	not defined under International Financial Reporting Standards (IFRS) or US generally accepted accounting principles (GAAP); no agreed way to adjust it, so use with caution

Operating income is also called earnings before interest and taxes (EBIT). EBITDA stands for earnings before interest, taxes, depreciation, and amortization. For most companies in the growth, mature and decline stages, net margin is still a useful measure across firms and over time.

$$\text{Net margin} = \dfrac{\text{net income}}{\text{revenue}},\quad \text{Operating margin} = \dfrac{\text{operating income}}{\text{revenue}},\quad \text{EBITDA margin} = \dfrac{\text{EBITDA}}{\text{revenue}}$$

Revenueeach level expressed as a margin of revenue

• EBITDA Memorize before D&A; compares leverage, taxes, investment policies; not IFRS or GAAP
  • Operating income Memorize after D&A; core profit; distorted by investment policy
    • Net income Memorize after financing, non-operating items, taxes; complete but hard to compare

How do cost components compare with peers?

Use it

Another way in is to break the cost structure into cost components as a share of sales , each as a percentage of sales, and follow them over time against peers. It shows whether the company is making progress on its strategy and stated goals, and sharpens the story behind the valuation.

	Year 1	Year 2	Year 3
Operating margin: Clearspring	16.7%	16.9%	17.2%
Operating margin: peer average	11.0%	11.4%	11.8%
Packaging: Clearspring / peers	24% / 27%	23% / 27%	23% / 26%
Wages: Clearspring / peers	12% / 16%	12% / 16%	11% / 15%
Energy and freight: Clearspring / peers	21% / 17%	22% / 17%	23% / 18%
Maintenance: Clearspring / peers	3.0% / 4.5%	2.8% / 4.4%	2.5% / 4.5%

Clearspring’s lower packaging and wage costs fit its cost leadership. But energy and freight take a bigger share of its sales than its peers’, because it trucks water from one large plant across the region. If energy costs rose 20% with prices unchanged, Clearspring’s margin would lose about 23 × 0.20 = 4.6 points and its peers’ about 18 × 0.20 = 3.6 points: a scenario to model. And its falling maintenance share needs checking: efficiency, or underinvestment that will catch up with it?

How do fixed costs create operating leverage?

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Operating leverage is the proportion of fixed to variable costs. It decides how stable margins are.

$$\text{Operating profit} = [Q \times (P - VC)] - FC$$

Here $Q$ is units sold, $P$ price per unit, $VC$ variable cost per unit and $FC$ total fixed operating costs. Variable costs move with output: inventory for a retailer, raw materials and hourly wages for a manufacturer. Fixed costs , stated as a total, do not change within a normal output range in the short run: salaries, D&A, software, insurance and some utilities.

Financial statements do not split costs into fixed and variable, so analysts estimate the split, for example with a regression of a cost line on revenue (financial statement forecasting shows how). The more a cost moves with revenue, the more variable it is. The estimate assumes the cost structure has not changed over the period.

Companies with a higher share of fixed costs see bigger changes in cash flow and profit for a given change in revenue. A carmaker, with plants and staff to pay whatever it sells, swings more over the cycle than a software reseller whose main cost is the licenses it buys for each sale.

Exam tip With high operating leverage, a 10% rise in revenue raises operating profit by more than 10%. With only variable costs, profit would move exactly 10%.

How much cash does working capital absorb?

Memorize

Financial Statement Analysis and Corporate Finance define a company’s operating cycle . How fast a company turns raw materials and inventory into cash can strengthen its competitive position and raise returns. Analysts measure it with activity ratios: inventory turnover, days of inventory on hand, receivables turnover, days sales outstanding and days payable outstanding.

Days of inventory on hand (DOH) is how long stock sits before it is sold, days sales outstanding (DSO) how long customers take to pay, days payable outstanding (DPO) how long the company takes to pay suppliers.

Working capitalcash tied up in the operating cycle

• Days of inventory on hand how long stock sits
• Days sales outstanding how long customers take to pay
• Days payable outstanding how long the company takes to pay
• Cash conversion cycle Memorize DOH + DSO − DPO; shorter frees cash, longer needs financing

$$CCC = DOH + DSO - DPO$$

A shorter cash conversion cycle (CCC) means efficient inventory and collections and good payment terms from suppliers, and so less working capital. A longer cycle is a use of cash that has to be financed.

$$DOH = \dfrac{\text{inventory}}{\text{cost of sales}} \times 365,\quad DSO = \dfrac{\text{receivables}}{\text{revenue}} \times 365,\quad DPO = \dfrac{\text{payables}}{\text{cost of sales}} \times 365$$

Financial Statement Analysis defines these, often with average balances; here they are a refresher.

How does strategy show up in working capital?

Use it

Operating cycles differ by industry. Manufacturers source raw materials and parts to fill orders; retailers buy and sell finished goods and try to collect quickly; software and telecommunications firms hold little working capital, because they make and ship no physical goods.

A narrow product range simplifies inventory and gives the buyer more bargaining power with suppliers, both of which shorten the cycle.

Makers of large, long-term products such as aircraft may value inventory by program accounting , which looks at the profitability of a whole program rather than the cost of each unit, so deferred production costs can build up in inventory.

Declining or negative working capital can be a significant source of funding, for example to repay debt. It is a strength when it comes from bargaining power, not from paying suppliers late because cash is short.

Go deeper Why negative working capital is not always good

A negative cycle can come from bargaining power, as when customers pay up front and suppliers accept long terms, or from distress, as when a company stretches suppliers because it cannot pay. The first is a durable source of funding; the second ends when suppliers tighten their terms. Check which by reading the payables trend next to cash and profit.