Profitable companies improves their profit margin over time

Recently I stumbled over this notion that Profitable companies will improve their profit margin over time. I don’t have a commerce/business background so I am little elated at this tiny discovery.

Profit margin gets diminished because expenses become huge. From a huge list of types of expenses, one of the biggest demons is loans.

For a company that is steadily making money will sooner or later (sooner the better) will be able to pay away its debts and hence will improve its profit margin as it will no longer have to pay the interests. This is impossible for a company that isn’t profitable.

Apart from the interests, there are several other kinds of expenses and it will be worthy to check out whether a profitable company will be able to wipe them out as it continues to make money.

So, Profitable companies will improve their profit margin over time. Waiting to hear what others have to say.

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Yes Ricky, great companies have their profit margins improving or sustaining over a longer period of time.

This is a summation of many other factors & indicates that the company has some distinctive advantages in the industry it operates. This cannot be looked in isolation, but has to be looked in conjunction to revenue growth.

Also, a small note : One has to cross check whether the profits are being converted to cash.

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Top line is a leading indicator, while bottom line is a lagging one. How about that conclusion?

Ricky, bottom line is usually much more volatile compared to top line. These are prone to:

  • key raw material prices going up
  • one time expenses, included in the EBITDA
  • temporary stress due to teething issue on commissioning of new facilities

The “Key” word here is “Temporary”. If you are able to identify these temporary issues in otherwise efficient and stable companies, you can be a good stock picker!

Also, look for companies with high operating margins. A high margin helps company tide over temporary stress as there is enough room to absorb margin contraction and still be profitable/solvent during stressful times.

Be alert though…margin erosion can also signal that company is going downhill permanently due to changing industry dynamics! So you can not always bank on margins getting back to average over time.

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There is a nice saying about this “Revenue is vanity. Profit is sanity. Cash is reality”". Neither Sales growth nor profit growth is the indicator of good business .There is a nice article about this.

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Yes Sushil. Very true.

One has to be extremely careful in understanding the causes of dips in profit margins.

A seemingly turnaround scrip can turn into a potential wealth eroder.

So, sufficient knowledge of the company & the industry it operates in is a Must , while identifying the temporary stress in margins.

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Correctly said @amitayu

A more proper conclusion should be like “FCF is a leading indicator, while bottom line is a lagging one.” What say?

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@amitayu
Nice article. Thanks for sharing.

@ricky_
Whats the hurry to draw conclusions ? : )
Let the learnings be.

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Correct!! Cash is King :slight_smile:

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Just checked out with a few companies, and this is what I must say:

Once you have managed to pay up all your debts and have stopped paying interests, you have hit( or almost near) the ceiling of operating profit margin. There is no room for further improvement as all other expenses continue to remain fixed for the rest of company’s life.

There is not much that you can do to wipe them out,no matter how much money you are making.

Views please

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Just 2 cents from my side.
FCF ensures that Profits do exist on Ground Reality & once realized.
Until & unless you are totally looking at Asset Heavy Industries such as Manufacturing, Capital Goods etc, which require huge Fixed Assets & their associated Depreciation & also with huge Capex requirements, so as to sustain their business, which obviously dyue to the intrinsic nature of business, most of the times will fail to generate FCF’s. These sort of Business are hard to be categorized as Cash cows.
Margins often take a back seat in such kind of businesses, exception being Management having fire in belly to grow against all odds & chalking out a well laid plan.

Topline & Bottomline are key indicators, which should be only seen in context of sustainability over a period of time
& over a complete business cycle i.e Ups & downs of Economy Cycle, how the business has gone against the tides & sailed well in the direction of winds.
This should give us a clear picture & conclusions can be drawn then after proper analysis of a business in context per se & not in general

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