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What are gross profit margins,  net profit margin, operating profit margins?

Gross, Net, Operating Profit Margin

understand the profitability ratio in detail In profitability ratio, we will see gross profit margin, operating profit margin, and pretax margin as well as net profit margin.  What are they and how are they calculated?

then we will see what they actually mean when you invest in the stock of any company So you compare it with other companies also and when you compare the profitability ratio of all companies then you would know the complete story of a company So Read this Concept from the beginning to the end so that you can understand the concept completely

Let's go straight to the blackboard So when we talk about profitability, then we talk about two types of returns

One of them is the return on sales which means, how much profit percentage is  earned on the sold goods the second one is the return on investment investment means the amount of capital applied whether by taking loans, by an investor, or by using your own money

how many returns did you get on it in total?

There are mainly 4 matrices in return on sales

First is Gross Profit Margin,

second is Operating Profit Margin

The third is Pretax Margin,

and the fourth one is Net Profit Margin

Return on Investment, there are Return on Assets(ROA), Operating Return  on Asset, Return on Total Capital including debt and equity then you can find out the return on equity separately and there is a return on common equity also which is mainly used for finding outstanding shares of listed companies now we will look into all these terminologies slowly we will concentrate mainly on the return of sales

we will look at Gross Profit Margin, Operating Profit Margin, Pretax Margin, and Net Profit in detail and will see in what ways we compare different companies general income statement to know in which way will you get all these heads

Let's take an example of a shoe manufacturing company and have a look at its income statement, it is a hypothetical example

assuming the  The revenue of this company in two years is, let's say 2,00,00,000 its Cost of goods sold, the cost of making the shoes which includes material and labor cost was 80,00,000 for one year So when you subtract the Cost of Goods Sold  from the Sales revenue, here revenue we are talking about is sales

so when you minus COGS, then you get the Gross Profit So 1,20,00,000 would be your Gross Profit From this, Let's say you subtracted 20,00,000 of marketing and sales  expenditure Office & admin expenses, let's say around 10,00,000 were also subtracted from it

So your EBITDA shows up, which is Earnings Before Interest Taxes Depreciation and Amortization So after subtracting these 30 lakhs, you get 90 lakhs Now what exactly is EBITDA, what  is EBIT, what is operating profit, 

After that, when you subtract Depreciation and Amortization from EBITDA Assume a loan was taken to put some planted machinery in this factory So we take Depreciation of such assets So let's say you subtract 10 lakh from it And let's say that the Amortization is zero So we  get EBIT from it, after subtracting Depreciation and Amortization from it Now your EBIT will be 80 lakhs So for practical purposes, this would be our Operating Profit.

I have made a detailed video on Operating Profit also where I talked about EBITDA, EBIT, and Operating Profit

So for practical purposes, I am assuming EBIT as Operating Profit because it contains only sales revenue, there is no other income If other income is there  , then you have to subtract it Other income like income from some interest in any investments If there is any rental income, then it won't be included in any sales

So that has to be subtracted, but since this, all is our sales revenue EBIT would be our Operating Profit

Now from EBIT, you subtract the interest, whenever interest portion is subtracted in any loan, then you get profit before taxes After that, you subtract the tax I am assuming approximately 30% tax which will be subtracted Then you  will get net profit So now let's see how to calculate all the margins

The first one you have is Gross Profit Margin The formula for Gross Profit Margin includes simply dividing Gross Profit by Net Sales we want to see how much percent  age of sales is our Gross Profit? Right?  So you will divide the Gross Profit by the revenue, that is net sales, which is 2,00,00,000 So if you want to find Gross Profit in this case 1 crore 20 lakhs, which can be written as 120 lakhs, divided by 200  lakhs

So this becomes 0.6 that means 60% is our Gross Profit Margin Then for Operating Profit Margin, you divide Operating profit by Net sales So in our case, Operating Profit is our EBIT SO this becomes 80 lakhs divided by 200 lakhs

This will come to  0.4, which means 40% is your Operating Profit Margin. Now if you want to find out Pretax Margin then you have to divide Profit Before Taxes (PBT) which is 60 lakhs By the Net Sales

So we will divide PBT 60 lakhs by 200 lakhs which comes to 0.3 that means you have a 30% Pretax  Margin

For Net Profit Margin, we will divide Net Profit by Net Sales So it will become 42 lakhs divided by 200 lakhs which basically becomes 0.21, which means 21% is your Net Profit Margin So this was all the calculation, now we will understand why  do we have to do these calculations

If you talk about Gross Profit Margin so when you will compare companies, then you would want to have its Gross Profit Margin as high as possible, its obvious every company would want that So how to get High Gross Profit  Margins?

Now, if pricing is high of any product then naturally that company can command its premium right? Its profits can be increased because of its pricing, that is Gross Profit Margin Or the product's cost should be very low

now, why would the pricing be higher? Because that company may have a competitive advantage, it may have a superior product now if we talk about iPhone, it is a superior product, right? So it also has a superior branding, which also gives it a competitive advantage Its technology can also be exclusive Because of this, any product can command higher pricing The other one is lower costs now how can the cost be lowered of any product?

Economies of scale, meaning putting a very larger scale of factories or the operational efficiencies were improved greatly So it lowers our cost, because of this Gross Profit Margin improves, so whenever you compare companies then you will see things like whose Gross Profit Margin is better And if Gross Profit Margin is good, then is it sustainable? meaning that if your initial Gross Profit Margin is good but you don't have exclusivity, you don't have an advantage in technology, neither in branding nor in product then it won't be sustainable

So you would have to focus on these things  while observing any company after that, we come on operating profit margin what does operating profit margin tell us?  and how is it different from gross profit margin? we calculated gross profit margin this much earlier by the gross profit after that, we see the expenses of marketing and sales, office and admin, and the costs of depreciation and amortization are all here

For example, let's assume the operating profit margin of any company is increasing and your gross profit margin is the same

so this means the company can control its operating cost nicely and if the growth of operating profit margin becomes lower than the gross profit margin that means  the company is not able to control these operating costs as marketing and sales, it may be this office and admin expenses are increasing Depreciation may have been considered too much this too can lower our operating profit margin

so operating profit margin can be understood mainly by operating  cost additionally when we compare it to gross profit margin now we will talk about Pretax Margin  t margin here this interest is different, interest is also subtracted from operating profit

now assume here it was 40 lakhs interest instead of 20 lakhs So our profit before tax would have been 40 lakhs only so when we calculated the pretax margin earlier which was 30%  , would now have remained 20% only so let's assume your company is paying a very high interest

So naturally, your pretax margin becomes lower now when you compare two companies, then you can see that assuming a company's operational efficiencies are very good, gross profit  margins are very high and assume slowly its interest portion is becoming shorter that means its situation is improving, its pretax margins would be improving

So pretax margins basically show us the effects of debts that if you have taken a loan then what effects would be there on  the margins by filling the interest portions

then in net profit, all your expenses are subtracted, whether it be operating expenses, or not operating expenses so it gives you t  he overall picture of a companies profitability net profit margin is quite common, whenever we talk of simple profit margin we talk about net profit margin only

net profit margin is compared foremost by anyone who's an analyst or anyone who wants to invest in stocks but net profit  margin doesn't tell you the whole story, that is why you need the gross profit margin operating profit margin, pretax margin, and net profit margin to be calculated when you compare one company to another

now we will talk about comparison on companies

that if  you want to compare on the profitability of companies, then how will you compare assuming you want to compare four companies then you may try to compare Asian paints with Infosys, Reliance, Tata Motors, and their gross profit margins, operating profit margin or net profit  margin by each other but this is an absolutely wrong way you should compare companies of the same sector now Asian Paints is a paint company, so you will compare it with a paint company only you will not compare it with a tech company like Infosys, Asian Paints will be compared with Akzo Nobel, Berger Paints, Nerolac

If you have to compare Infosys, then you will do it with TCS, Wipro, Cognizant a similar type of companies  have to be compared and we have to see whose margins are becoming better over a period of time.

Markup vs Profit Margin - Explained

I am going to discuss a very simple topic Markup Vs Marin  We will see what is the difference between markup and profit margin

Markup is a similar term of profit margin Many people get confused about markup and profit margin

we'll see what is their difference? If I give you an example If the markup of any product is 50%. Assume you are selling a product or you buy a product So if the markup is 50% then the profit becomes 33%

So we will clear this confusion And we will see how the calculation is done? 

Let's understand this with the help of an example

There is a shoe manufacturing company and The cost of making a shoe is 400 Rs And it sets the price of a pair of shoes is 600 Rs So first we will calculate the profit per unit. So here we are talking about profit per unit. We are talking about gross profit We are not talking about net profit

What is the gross profit?

It's price- cost

What is the price?

600 - 400(cost)

So what is the profit per unit

It is 200 Rs

So if we have to calculate the profit margin

Then what is the profit margin?

Profit/price

So we are talking about gross profit We are talking about gross profit margin So what will we do here?

What is the gross profit?  

It was 200 Rs. What is the price? 600 Rs We will divide 200 from 600. What is the answer? It is 0.3333 If I write it in percentage then it is 33.33%

What is its meaning? 33.33% of the price is your cost.

When you will calculate 33.33% of 600 Then you will get 200 Rs

So if we say it in other words then what will happen is When you subtract profit margin from price then When you subtract (1-% of profit margin) Then what will you get? We will get the cost.

So in this way, if you want to learn this formula then you can do it. Otherwise, as I have told you intuitively

If you will do it by understanding first then you can do it easily. You will not face any major problems. I will also tell you about its application that how is its application? So this was about how to calculate the profit margin Remember this, the profit margin is profit as a percentage of the price.

Similarly, the markup is the percentage of the cost. So if we have to calculate markup

in this example

Then if our profit is 200 Rs Then we will divide profit by cost. What is the cost? It is 400 Rs. So when you will divide 200 by 400 then you'll get 0.5 That means your markup is 50% So understand this intuitively what it means is

At your cost, How much markup percentage should you add That you will get your final price. This is the markup percentage. If we do the opposite of it How much profit margin is to be deducted from the price to get your cost?

Please remember this thing. If you understand this thing then you will not get confused. So I will tell you about the markup. If you want to calculate the price from the markup then what will you do? Then you will do cost×(1+markup%) How much markup percentage you should add to get the price So if you want then you can remember it. But you will not need it. What you have to is you have to remember this diagram We add markup percentage to the cost And deduct the profit margin percentage from the price.

Then we get the cost. I will give you one more example.

Assume if we know the markup percentage and profit margin percentage And we want to calculate the price then what will we do? Assume the shoe manufacturing company sold the shoes to a shoe retailer The price was 600 Rs So the cost of the shoe retailer is 600 Rs Because he has bought from a shoe manufacturing company at 600 Rs Now we want that the shoe retailer to know the price. Assume he wants to earn some profit margin He wants to know his price. Let's say he says that

He wants to earn a profit margin of 40% So tell me what price I should set? See what we calculated?

Price×(1-% of profit margin)

is equal to cost. This means if you deduct profit margin from the price Then you will get the cost That means your price would be

Cost/1-% of profit margin

So how much is it? Cost is 600 Rs divided by 1-0.4 The percentage of profit margin is 40%
So divide it by 0.4 Then how much will it be? 600/0.6

What would be your price? It should be 1000 Rs

So that your profit margin percentage will be 40% Similarly, I will give you an example of markup Assume your cost was 400 Rs And let's say you want to earn 50% markup on it What price should you keep? What formula did we see in this price is equal to we increase the cost by markup percentage So we will increase it by markup percentage. So what is our cost? 400 Rs. So you will do 400(1+ 0.5) So it will be 400×1.5 So it will be 600 Rs Similarly, you can decide your pricing for any product You have a target, one is markup percentage Or there is a target of profit margin

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