Using Key Measures to Evaluate a Company’s Operating Profitability and Working Capital

Operating profitability and working capital are two key measures used to evaluate a company’s financial health. Operating profitability measures how much profit a company makes on a dollar of sales after paying for variable production costs but before paying interest or tax. Working capital, on the other hand, is a measure of both a company’s operational efficiency and its short-term financial health. It is calculated as current assets minus current liabilities.

Operating Costs

Operating costs are expenses associated with the day-to-day operations of a business. For example, in a manufacturing company, these costs might include raw materials, direct labor costs, and overheads such as rent and utilities. Operating costs also include the management of business activities and compliance with laws and regulations. For instance, a pharmaceutical company would have to bear costs related to regulatory compliance and quality control.

Operating costs account for the majority of costs for most companies and are primarily determined by the company’s business model and size. For instance, a software development company would have high research and development costs, while a retail company would have high inventory costs.

Recall that financing costs include payments to debt and equity investors as a return on their investment. For example, a company that has issued bonds would have to bear interest costs, which are a type of financing cost. On the other hand, Financing costs include payments to debt and equity investors as a return on their investment. For example, a company that has issued bonds would have to bear interest costs, which are a type of financing cost.

Classification of Operating Costs

Operating costs can be categorized into three groups: by their behavior with output, their nature, or their function. Consider the following table:

$$\begin{array}{l|l|l}
\textbf{Categories} & \textbf{Description} & \textbf{Types} \\
\hline
\textbf{Behavior with} & \text{Costs change with} & \text{Variable and Fixed} \\
\textbf{Output} & \text{production or service} & \text{costs, short-term} \\
& \text{levels (short term)} & \text{fluctuation regardless} \\
& & \text{of volume} \\
\hline
\textbf{Nature (Type} & \text{Specific expenditure} & \text{Raw goods and} \\
\textbf{of costs)} & \text{category or nature} & \text{Office essentials} \\
\hline
\textbf{Function (Purpose} & \text{Primary expense reason} & \text{Employee salaries,} \\
\textbf{of Cost)} & \text{or objective} & \text{Product manufacturing,} \\
& & \text{Promotional activities,} \\
& & \text{Administrative tasks,} \\
& & \text{Innovation, improvement} \\
\end{array}$$

Fixed and Variable Costs

Operating costs are essential components of a company’s financials, influencing profitability. To analyze a firm’s potential profitability and cost structure, these costs can be divided into fixed and variable components.

1. Fixed Costs (FC)

Fixed costs remain unchanged over a specific period or range of production levels. Even if a company produces more or fewer units, these costs stay constant.

• Examples:
  • Salaries: Monthly salaries paid to employees are fixed costs. Whether the company produces 100 or 1,000 units, these salaries remain the same.
  • Depreciation: The depreciation of machinery or equipment doesn’t change with the number of units produced.
  • Rent: Rent for a factory or office space remains constant, regardless of production levels.

2. Variable Costs (VC)

Variable costs change with the level of production or services provided. When production increases, variable costs go up, and vice versa.

• Examples:
  • Materials: The more units produced, the more materials are required, increasing the cost.
  • Direct Labor: In some industries, labor costs may increase with more units produced, especially if overtime or additional shifts are needed.
  • Utilities: Operating machinery for longer periods might increase electricity costs.

Operating Profit Calculation

The relationship between fixed and variable costs, the number of units sold, and the sale price determines the operating profit of a company. Here’s how it’s calculated:

\[ \text{Operating Profit} = [Q \times (P – VC)] – FC \]

Where:

Q = Units of outputs sold in a period.

P = Price per unit of output.

VC = Variable operating costs expressed per unit of output. 

FC = Fixed operating costs, which do not change within a given range of output in
the short run.

Example: Calculating Operating Profit

Let’s consider a company, ‘ToyBox Inc.,’ that manufactures toys:

• Fixed Costs (FC) = $10,000 monthly (includes salaries, rent, and depreciation)
• Variable Costs (VC) = $5 per toy (includes materials and direct labor)
• Each toy is sold for a price (P) = $20

If ToyBox Inc. sells 1,000 toys (Q) in a month, the operating profit can be calculated as:

\[ \text{Operating Profit} = [1,000 \times ($20 – $5)] – $10,000 = $5,000 \]

This means that after covering all fixed and variable costs, ToyBox Inc. has made a profit of $5,000.

Operating Leverage

The amount of fixed costs in the operating cost structure of a company is referred to as operating leverage. The contribution margin is the difference between the price of a unit and the variable costs. It is calculated as (P- VC).

Operating leverage presents both benefits and risks. If operating costs are largely fixed, and the contribution margin is positive, operating profit can increase rapidly with increases in Q. However, if Q declines, since fixed costs do not change, operating profit will fall.

Degree of Operating Leverage (DOL)

Operating leverage can be measured and compared across firms using the degree of operating leverage (DOL). A firm can increase its DOL by increasing the fixed costs and decreasing the variable costs in its cost base.

Degree of Operating Leverage can be calculated as $$DOL = \frac{\% Δ \text{Operating Profit}}{\%Δ \text{Sales}}$$

Where:

• % Δ Operating Profit = Percentage change in operating profit.
• % Δ Sales = Percentage change in sales.

Example:  Calculating the Degree of Operating Leverage (DOL)

Based on the data below, the degree of operating leverage for TechPulse Inc. for the year ended 31 December 20Y2 is closest to:

$$
\begin{array}{l|c|c}
{}& \textbf{31 December 20X2} & \textbf{31 December 20X1} \\
\textbf{Description} &\textbf{(in millions of EUR)}&\textbf{(in millions of EUR)}\\ \hline
\text{Revenue} & 15,000 & 14,000 \\
\hline
\text{Costs of goods sold} & 7,500 & 7,000 \\
\hline
\text{Selling, general, and administrative expenses} & 2,000 & 1,900 \\
\hline
\text{Research and development expenses} & 1,800 & 1,700 \\
\hline
\text{Other operating expenses} & 500 & 480 \\
\hline
\text{Interest expense} & 350 & 330 \\
\hline
\text{Other (income) expense} & 50 & (80) \\
\hline
\text{Income before income taxes} & 2,900 & 2,670 \\
\hline
\text{Provision for income taxes} & 580 & 534 \\
\hline
\text{Net income} & 2,320 & 2,136 \\
\end{array}
$$

Solution:

Given the financial data for TechPulse Inc., we can calculate the percentage change in Sales and the percentage change in Operating Profit to determine the Degree of Operating Leverage (DOL).

Step 1: Calculating the Percentage Change in Sales

\[ \% \Delta \text{Sales} = \frac{\text{Sales}_{20X2} – \text{Sales}_{20X1}}{\text{Sales}_{20X1}} \times 100 \]

Using the provided data:

\[ \% \Delta \text{Sales} = \frac{15,000 – 14,000}{14,000} \times 100 = 7.14\% \]

Step 2: Calculating the Percentage Change in Operating Profit

\[ \% \Delta \text{Operating Profit} = \frac{\text{Operating Profit}_{20X2} – \text{Operating Profit}_{20X1}}{\text{Operating Profit}_{20X1}} \times 100 \]

Using the provided data:

\[ \text{Operating Profit}_{20X1} = 14,000 – 7,000 – 1,900 – 1,700 – 480 = 2,920\]

\[ \text{Operating Profit}_{20X2} = 15,000 – 7,500 – 2,000 – 1,800 – 500 = 3,000\]

\[ \% \Delta \text{Operating Profit} = \frac{3,200 – 2,920}{2,920} \times 100 = 9.59\% \]

Step 3: Calculating the DOL

\[ DOL = \frac{\% \Delta \text{Operating Profit}}{\% \Delta \text{Sales}} = \frac{9.59}{7.14} = 1.34 \]

The Degree of Operating Leverage (DOL) for TechPulse Inc. for the year is 1.34. This indicates that for every 1% increase in sales, the operating profit would increase by 1.34%.

Natural and Functional Operating Cost Classifications

Instead of classifying operating costs as fixed and variable, both the International Financial Reporting Standards (IFRS) and the US Generally Accepted Accounting Principles (GAAP) allow companies to present operating costs in two main ways: Natural cost classification and Functional cost classification. Each presentation method is influenced by accounting standards and the specifics of a company’s industry and history.

Natural Cost Classification

The natural cost classification method classifies costs based on their nature. For instance, salaries, rent, utilities, and raw materials. In a company’s income statement with natural classification, expenses are listed as they are, without grouping them under broader functional categories.

Functional Cost Classification

In Functional cost classification, costs are grouped based on the function they serve in the business. Common functions include Cost of Sales (or Cost of Goods Sold), Selling Expenses, General and Administrative Expenses, and Research and Development Expenses.

For example, salaries might be divided between “Selling Expenses” (for sales staff) and “General and Administrative Expenses” (for office staff). This provides a clearer picture of how much is being spent on each business function.

If a company uses the functional classification method, its income statement will have a standardized structure. This makes it easier for stakeholders to compare financials across companies in the same industry.

The way a company classifies its costs gives stakeholders insights into its operations and spending patterns. Whether you’re looking at costs by their nature or by the function they serve, understanding these classifications helps in analyzing a company’s financial performance.

Measures of Operating Profitability

The functional classification of operating costs allows analysts to calculate and distinguish crucial operating profitability measures used in analysis and forecasting. Operating profitability provides insights into a company’s core business performance without considering external factors like interest, taxes, or other non-operational costs. 

Key measures of operating profitability include:

Gross Profit:

Gross profit is the difference between revenues and the direct costs associated with producing goods or services (Cost of Sales or Cost of Goods Sold). That is:

$$\text{Gross Profit = Revenue – Cost of Sales}$$

Gross profit provides an initial insight into a company’s production efficiency and pricing strategy.

Gross Margin:

Most of the cost of sales tends to be variable, implying that gross margin can serve as an approximate measure of the contribution margin. Gross margin is calculated using the gross profit as:

$$\text{Gross Margin} = \frac{\text{Gross Profit}}{\text{Revenue}}$$

EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization):

EBITDA measure provides a view of profitability from core operational activities by excluding interest, taxes, and the non-cash expenses of depreciation and amortization. It is calculated as:

$$\text{EBITDA = Revenue – (Cost of Sales+Operating Expenses)}$$

EBITDA is often used to compare profitability between companies and industries as it eliminates the effects of financing and accounting decisions.

EBITDA Margin:

EBITDA margin is calculated using the EBITDA as:

$$\text{EBITDA Margin} = \frac{\text{EBITDA}}{\text{Revenue}}$$

Operating Profit [EBIT (Earnings Before Interest and Taxes)]:

Also known as operating profit, EBIT further narrows down profitability by considering depreciation and amortization costs but still excluding interest and taxes. It is calculated as:

$$\text{Operating Profit (EBIT) = Revenue – (Cost of Sales+Operating Expenses+ Depreciation and Amortization)}$$

EBIT offers a snapshot of a company’s operational profitability and its ability to cover its operating expenses.

EBIT or Profit Margin:

EBIT margin is calculated using EBIT as:

$$\text{EBIT margin} = \frac{\text{EBIT}}{\text{Revenue}}$$

Cost Drivers

The notes accompanying financial statements offer invaluable insights about the composition and nature of operating costs. Analysts and investors can dive into these notes to gain a deeper understanding of a company’s cost structure and operational efficiency.

For most companies, the major driver of operating costs over the long run is output. This is because output growth often requires growth in assets, human capital, and purchased goods and services. Since output or revenue is a major cost driver, analysts often express operating costs as a percentage of revenue. Moreover, analysts consider industry profitability, economies of scale, and economies of scope.

Industry Profitability, Economies of Scale, and Economies of Scope

• The profitability of an industry is not just a function of the goods and services it produces. The internal competitive dynamics and the relative positioning of firms within that industry deeply influence it. Over the long term, the intensity of competition, barriers to entry, threats from substitutes, and bargaining power of both suppliers and customers collectively determine how lucrative an industry is.

For example, The smartphone industry is dominated by a few key players like Apple and Samsung. These giants have established strong brand identities and have significant market shares. Their dominant position and the high costs associated with entering the smartphone market deter new entrants, keeping the industry profitability high for these established players.

• Economies of scale refer to a decline in costs per unit as output grows. This generally results from having fixed costs in the cost structure that are spread over more units of output. A company with entirely variable costs can also exhibit some economies of scale over time if it increases its bargaining power over suppliers as it grows, driving down variable costs per unit.
• Economies of scope refer to a decline in costs per unit as the number of products or business lines increases. This generally results from shared costs between the product lines. Examples of economies of scope can be found in financial services, where there are customer, client service, compliance, technology, and back-office similarities (and thus cost efficiencies) across various lines of business.

For example, A bank offers both credit card services and home loans. While these are distinct services, they might share customer service platforms, IT infrastructure, or even regulatory compliance systems. By leveraging these shared resources, the bank reduces the per-unit cost for each service, showcasing economies of scope.

It’s important to note that claims of economies of scale or scope should be corroborated empirically.

Working Capital and Working Capital Management

Recall that working capital is calculated as:

$$\text{Working Capital} = \text{Current Assets} – \text{Current Liabilities}$$

Where:

• Current Assets are assets that are expected to be used, consumed, or converted into cash within one year or within the normal operating cycle of a business, whichever is longer.
• Current Liabilities are the company’s debts or obligations that are expected to be settled within one year or within the firm’s normal operating cycle, whichever is longer.

Working capital management is a key measure of a company’s financial health. It involves managing the company’s current assets and current liabilities to ensure it has enough to meet its short-term obligations and operating expenses.

The primary measures of a company’s working capital management are activity ratios that determine the cash conversion cycles and net working capital to sales ratios.

Cash Conversion Cycle

The cash conversion cycle is a key measure of a company’s working capital management. It determines how quickly a company can convert its investments in inventory and other short-term assets into cash. It is calculated as:

$$\text{Cash Conversion Cycle = DOH + DSO – DPO}$$.

Where:

DOH  = Days of inventory on hand.

DSO = Days sales outstanding.

DPO = Days payable outstanding.

A short cash conversion cycle means that the company requires less external financing to fund operations. This is beneficial as it reduces the company’s reliance on external financing and can improve its profitability.

Net Working Capital to Sales Ratio

The net working capital to sales ratio determines the level of investment, in addition to capital investments, that cannot be distributed to investors. This ratio is important as it provides an indication of the company’s ability to generate sales from its working capital. A high ratio may indicate that the company is not efficiently using its working capital to generate sales.

The Net Working Capital to Sales Ratio is calculated as:

$$\text{Net Working Capital to Sales Ratio} = \frac{\text{Net Working Capital}}{\text{Sales}}$$

Where:

$$\begin{align}\text{Net Working Capital}=&\text{(Current assets, excluding cash and marketable securities)} -\\& \text{(Current liabilities, excluding short-term and current debt)}\end{align}$$

Negative net working capital means that the company’s current liabilities exceed its current assets. This implies that suppliers are a source of financing for the company. While this can provide short-term financing, it may not be sustainable in the long term and could indicate financial distress.

Question #1

 Which of the following most likely indicates a negative net working capital?

1. Suppliers are a source of financing for the company.
2. The company is efficiently using its working capital to generate sales.
3. The company requires less external financing to fund operations.

The correct answer is A.

Negative net working capital implies that a company’s current liabilities exceed its current assets. This situation indicates that suppliers are a source of financing for the company. When a company has negative net working capital, it means that it is financing its operations largely through trade credit, i.e., by delaying payments to its suppliers. This can be a sign of financial distress, as it suggests that the company is not generating enough cash from its operations to meet its short-term obligations.

In certain industries, like retail, having negative net working capital might indicate effective inventory management. It means companies can sell their goods rapidly, generating revenue before they owe their suppliers. So, while negative net working capital could seem concerning, it doesn’t always mean a company is in bad financial shape.

B is incorrect. Negative net working capital does not necessarily indicate that the company is efficiently using its working capital to generate sales. While it is true that a company with negative net working capital may be able to quickly turn over its inventory, this is not always the case. In fact, negative net working capital can also be a sign of financial distress, as it suggests that the company is not generating enough cash from its operations to meet its short-term obligations.

C is incorrect. Negative net working capital does not imply that the company requires less external financing to fund operations. On the contrary, it suggests that the company is relying heavily on external financing, specifically trade credit, to fund its operations. This can be a sign of financial distress, as it suggests that the company is not generating enough cash from its operations to meet its short-term obligations.

Question #2

Industry profitability is largely dictated by market structure and a company’s competitive positioning. What most likely determines industry profitability in the long run?

1. Competitive forces within the industry.
2. The company’s operating costs.
3. The company’s financing costs.

The correct answer is A.

Long-term industry profitability hinges on the competitive forces at play. This idea originates from Michael Porter’s Five Forces Framework, which states that the competitive landscape within an industry impacts the profitability of all its companies. These five forces consist of new entrant threats, buyer negotiation power, supplier negotiation power, threats from substitute products or services, and the level of competitive rivalry.

These forces shape the pricing power, costs, and investment required in an industry, thereby influencing the industry’s overall profitability. A highly competitive industry, for example, may have low profitability due to high competition, low barriers to entry, and high bargaining power of buyers and suppliers. Conversely, an industry with few competitors and high barriers to entry may have high profitability.

B is incorrect. While a company’s operating costs can affect its individual profitability, they do not determine industry profitability in the long run. Operating costs can vary widely between companies within the same industry due to differences in efficiency, scale, technology, and other factors. Therefore, while controlling operating costs is crucial for a company’s profitability, it does not dictate the profitability of the industry as a whole.

C is incorrect. Similar to operating costs, a company’s financing costs can impact its individual profitability but do not determine industry profitability in the long run. Financing costs are related to the way a company finances its operations and investments and can vary significantly between companies based on their capital structure, creditworthiness, and interest rates. Therefore, while financing costs can affect a company’s bottom line, they do not dictate the profitability of the entire industry.