Caution: High profit margins are not the sole indicator of a stock’s strength

profit margins

Does a company with excellent Profit Margins make the perfect choice for investment? Do growing net profits indicate the company’s financial strength? Not always!

Though Profit Margins serve as a critical indicator of the company’s performance, they are certainly not the only parameter you should look at to judge its financial strength. High Profit Margins can be reported through manipulative accounting and the underlying truth might be quite different.

Free Cash Flows – A good indicator of business strength

We just said that high Profit Margins do not guarantee the company’s financial performance. Then what does?

Free Cash Flows are accepted as an important factor in determining the health of a business. Unlike Profit Margins, it is difficult to manipulate this metric from an accounting standpoint. This makes it a robust parameter for assessing a company’s current situation.

Free Cash Flow refers to the disposable cash available with the business after paying off all the expenditures – operational and capital – in a fiscal year.

A positive Free CashFlow means that the company has enough funds to reinvest and utilize for business growth. It can be used for purchasing additional assets, expanding operations, increasing manpower strength, acquisitions and mergers and more, each of which can stimulate the business’s financial performance.

On the other hand, a negative Free Cash Flow can be considered as a sign of a weakness for the business. Expansion of debt or selling of equity can be a few measures that a business may adopt to combat this situation and sustain its expenditure.

Reasons why Profit Margins and Free Cash Flow may not be in sync

By now, we know that Free Cash Flow is an important indicator to assess any business. But should rise in Profit Margins not necessarily mean a rise in disposable cash? Don’t the two move in tandem?

Let us understand this through an example.

Imagine running a business where your sale volumes are increasing year on year and the business reports a consistent increment in the Profit Margins. An investor might perceive your company worthy of investment. However, when you take a look at the free cash balance in the bank, you are surprised to see that it is much below your expectations. Though you have booked enormous profits, your business lacks disposable cash. This clearly means that the rise in sales and profits did not convert into an incremental Free Cash Flow. But, why so?

Here are some possible reasons:-

1. Most of your business transactions are made via credit. Though the business has multiplied its turnover and shown a jump in its profit, the sale proceeds have not yet been realized from the creditors.

2. The business has accumulated a huge inventory and paid the cost for it. Though this does not amount to a loss, it does mean a large cash outflow.

3. The business has invested substantially in Research & Development. Though it is not accounted for as an expenditure in your books, it has contributed enormously to your cash outflow.

Here is a list of companies that have reported net profits for a decade and most of them have shown a consistent increase in YoY sale volumes. Yet, all of them have negative free cash flows.

Companies reporting PAT without Free Cash Flows over the past 10 years…

profit margins

Source: Wealth Insight, December 2019.

Conclusion

So, what should an investor do? Should he ignore the Profit Margins and just go by the amount of Free Cash Flow?

The best way to evaluate a company is by keeping a close watch on both the parameters. Just ensure that the High Net Margins are in sync with consistently rising Free Cash Flow. The simultaneous rise in both will ensure that the profits booked by the company are also realized in cash, leaving the company enough scope for expansion and growth.

You May Also Like: How to get assured allotment in an IPO

Disclaimer:

We, Ventura Securities Ltd, (SEBI Registration Number INH000001634) its Analysts & Associates with regard to blog article hereby solemnly declare & disclose that:

We do not have any financial interest of any nature in the company. We do not individually or collectively hold 1% or more of the securities of the company. We do not have any other material conflict of interest in the company. We do not act as a market maker in securities of the company. We do not have any directorships or other material relationships with the company. We do not have any personal interests in the securities of the company. We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships. We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.

Leave a Reply