Chapter 9
FINANCIAL ANALYSIS : Margin analysis: Structure

ALL PARTS
  • FINANCIAL ANALYSIS
  • INVESTORS AND MARKETS
  • VALUE
  • CAPITAL STRUCTURE POLICIES
  • FINANCIAL MANAGEMENT

The first step in any financial analysis is to analyse a company's margins. This is absolutely vital because a company that fails to sell its products or services to its customers above their cost is doomed.

An analysis of margins and their level relative to those of a company's competitors reveals a good deal about the strength of a company's strategic position in its sector.

Operating profit, which reflects the profits generated by the operating cycle, is a central figure in income statement analysis. First of all, we look at how the figure is formed based on the following factors:

  • sales, which are broken down to show the rate of growth in volumes and prices, with trends being compared with growth rates in the market or the sector;
  • production, which leads to an examination of the level of unsold products and the accounting method used to value inventories, with overproduction possibly heralding a serious crisis;
  • raw materials used and other external charges, which need to be broken down into their main components (raw materials, transportation, distribution costs, advertising, etc.) and analysed in terms of their quantities and costs;
  • personnel cost, which can be used to assess the workforce's productivity (sales/average headcount, value-added/average headcount) and the company's grip on costs (personnel cost/average headcount);
  • depreciation and amortisation, which reflect the company's investment policy.

Further down the income statement, operating profit is allocated as follows:

  • net financial expense, which reflects the company's financial policy. Heavy financial expense is not sufficient to account for a company's problems, it merely indicates that its profitability is not sufficient to cover the risks it has taken;
  • non-recurring items (extraordinary items, some exceptional items and results from discontinued operations) and the items specific to consolidated accounts (income or losses from associates, minority interests, impairment losses on fixed assets).
  • corporate income tax.

Diverging trends in revenues and charges produce a scissors effect, which may be attributable to changes in the market in which the company operates, e.g. economic rents, monopolies, regulatory changes, pre-emptive action, inertia. Identifying the cause of the scissors effect provides valuable insight into the economic forces at work and the strength of the company's strategic position in its sector. We are able to understand why the company generates a profit, and get clues about its future prospects.