Corporate Finance Theory and Practice, Third Edition

Chapter 9

MARGIN ANALYSIS: STRUCTURE

If financial analysis were a puppet, company strategy would be pulling its strings

An analysis of a company's margins is the first step in any financial analysis. It is a key stage because a company that does not manage to sell its products or services for more than the corresponding production costs is clearly doomed to fail. But, as we shall see, positive margins are not sufficient on their own to create value or to escape bankruptcy.

Net income is what is left after all the revenues and charges shown on the income statement have been taken into account. Readers will not therefore be very surprised to learn that we will not spend too much time on analysing net income as such. A company's performance depends primarily on its operating performance, which explains why recurring operating profit (or EBIT) is the focus of analysts' attention. Financial and non-recurrent items are regarded as being almost “inevitable” or “automatic” and are thus less interesting, particularly when it comes to forecasting a company's future prospects.

For the purposes of this chapter, we will assume that the analyst has drawn up an income statement as shown on p. 170, which will serve as a point of reference. What's more, we will assume that additional information, such as average headcount, sales and production volumes, is also available, as well as industry data, such as prices in the sector and rivals' market share.

The first step in margin analysis is to examine ...