Question 7.12: Evaluation of Profitability Ratios An analyst is evaluating ......
Evaluation of Profitability Ratios
An analyst is evaluating the profitability of Daimler AG (Xetra: DAI) over a recent five-year period. He gathers the following revenue data and calculates the following profitability ratios from information in Daimler’s annual reports: (Table 1)
Daimler’s revenue declined from 2007 to 2008 and from 2008 to 2009. Further,
Daimler’s 2009 revenues were the lowest of the five years. Management’s discussion of the decline in revenue and EBIT in the 2009 Annual Report notes the following:
The main reason for the decline [in EBIT] was a significant drop in revenue due to markedly lower unit sales in all vehicle segments as a result of the global economic downturn. Cost savings achieved through permanent and temporary cost reductions and efficiency improvements realized through ongoing optimization programs could only partially compensate for the drop in revenue.
1 . Compare gross profit margins and operating profit margins over the 2005 to 2009 period.
2 . Explain the decline in operating profit margin in 2009.
3 . Explain why the pretax margin might have decreased to a greater extent than the operating profit margin in 2009.
4 . Compare net profit margins and pretax margins over 2007 to 2009
| 2009 | 2008 | 2007 | 2006 | 2005 | |
| Revenues (€ millions) | 78,924 | 98,469 | 101,569 | 99,222 | 95,209 |
| Gross profit margin | 16.92% | 21.89% | 23.62% | 20.60% | 19.48% |
| Operating profit (EBIT) margin^\text{a} | –1.92% | 2.77% | 8.58% | 5.03% | 3.02% |
| Pretax margin | –2.91% | 2.84% | 9.04% | 4.94% | 2.55% |
| Net profit margin | –3.35% | 1.73% | 4.78% | 3.19% | 2.37% |
| (Table 1) | |||||
^\text{a}EBIT (Earnings before interest and taxes) is the operating profit metric used by Daimler.
1: Gross profit margin improved from 2005 to 2007 as a result of some combination of price increases and/or cost control. However, gross profit margin declined from 2007 to 2009. Operating profit margin showed a similar trend. In 2009, the operating profit margin was negative.
2: The decline in operating profit from 2.77 percent in 2008 to –1.92 percent in 2009 appears to be the result of Daimler’s operating leverage. Management indicated that revenue declined in 2009 and reductions in expenses were not enough to offset the revenue decline. Management tried to increase efficiency and reduce costs, including personnel expenses, but this did not sufficiently counteract the decrease in revenues. Expenses thus increased as a proportion of revenue, lowering the gross and operating profit margins. This is an example of the effects of operating leverage (fixed costs that could not be reduced) on profitability. In general, as revenue increases, to the extent that costs remain fixed, operating profit margins should increase. As revenue declines, the opposite occurs.
3: Pretax margin was down substantially in 2009, indicating that the company may have had some non-operating losses or high interest expense in that year. A review of the company’s annual report confirms that the cause was higher net interest expense. Specifically, the company increased financing liabilities, faced higher financing costs because of higher risk premiums on borrowing, and had lower interest income on investments. This is an example of the effects of financial leverage on profitability.
4: Net profit margin followed the same pattern as pretax margin, increasing from 2005 to 2007 and then decreasing from 2007 to 2009. In the absence of major variation in the applicable tax rates, this would be expected as net profit margin is based on net income while pretax margin is based on EBT, and net income is EBT(1 – Tax rate).