4.1 Profitability and Margins

Vertical Analysis and Horizontal Analysis

CFI's Financial Analysis Fundamentals core course — required for the FMVA credential and sitting inside the Finance domain of the final exam — starts profitability work with two mechanical tools, not with a list of named ratios. Vertical analysis (common-size analysis) divides every income-statement line by revenue in the same period. Horizontal analysis measures change through time. The year-over-year formula CFI uses is:

Period N / Period N-1 − 1

CFI's own illustration is revenue of 55,749 in Year 3 divided by 53,494 in Year 2, minus one, which equals 4.2%. That 4.2% is a growth rate. It is not a dollar change, and it is not a margin. Keep three ideas in separate columns:

1. A common-size percent is a line divided by revenue.
2. A growth rate is a line divided by that same line in the prior period, minus one.
3. A margin is a profit line divided by revenue.

Mixing those denominators is the fastest way to miss an FMVA analysis item even when the arithmetic is grade-school simple. Vertical analysis is how you read COGS% and SG&A%. Horizontal analysis is how you tell whether those percentages moved because the business improved or because revenue fell. You need both on the same page before you interpret any named margin.

Worked Income Statement in Dollars and Percents

Harbor Components is the fictional manufacturer used for the rest of this chapter. Year 2 and Year 3 results:

Year 3 revenue growth is 80,000,000 / 76,000,000 − 1 = 5.3%. That is the same formula as CFI's 55,749 / 53,494 − 1 = 4.2%; only the company numbers differ. COGS grew 4.3%, slower than revenue, so gross margin expanded from 30,000,000 / 76,000,000 = 39.5% to 40.0%. SG&A excluding D&A stayed at 15.0% of revenue. The income statement in dollars and the income statement in percents are the same story told two ways. If you only look at the dollar increase in gross profit ($2.0 million), you miss that the rate of profit on each sales dollar also improved.

EBITDA in Year 3 is EBIT + D&A = 16,000,000 + 4,000,000 = $20,000,000. EBITDA margin = 20,000,000 / 80,000,000 = 25.0%. Write that 25% next to the 20.0% EBIT margin so you never treat them as one number.

Gross margin and COGS percent

Gross profit = Revenue − cost of goods sold (COGS).

Gross margin = Gross profit / Revenue.

COGS% = COGS / Revenue = 1 − Gross margin.

Harbor Year 3: 32,000,000 / 80,000,000 = 40% gross margin. COGS% = 48,000,000 / 80,000,000 = 60%. If a question gives you a 60% COGS ratio, gross margin is 40% without another workbook tab.

COGS for a manufacturer usually includes materials, production labor, and manufacturing overhead. Overhead can include plant depreciation if the company classifies factory D&A in COGS. That classification is why gross margin is not the same thing as contribution margin, which we compute below.

Exam trap: a falling COGS dollar amount is not automatically good news. If revenue fell faster, COGS% rose and gross margin compressed. Always pair the dollar walk with the vertical percent.

Operating margin, SG&A percent, and EBIT

Operating income and EBIT (earnings before interest and tax) are the same line in a clean FMVA case: profit after COGS and operating expenses, before financing and tax.

EBIT margin = operating margin = EBIT / Revenue.

Harbor: 16,000,000 / 80,000,000 = 20%.

SG&A% = selling, general, and administrative expense / Revenue. Harbor's SG&A excluding D&A is 12,000,000 / 80,000,000 = 15%. D&A is another 5% of revenue. Together they consume 20 points of the 40-point gross margin and leave a 20% EBIT margin. If SG&A% rises while gross margin is flat, EBIT margin falls even though the factory did not get worse — headquarters or selling cost did.

If D&A sits partly in COGS (factory) and partly in SG&A (head-office systems), EBIT is still after all D&A, but an EBITDA add-back has to pull D&A from both lines. CFI cases usually show a separate D&A line under operating expenses so the add-back is one cell. Read the case. Do not assume the mapping.

Exam trap: an investor presentation that calls a number operating margin after adding back restructuring, stock-based compensation, and D&A is not EBIT margin. That is an adjusted margin. Use the definition the question states, not the label in a marketing deck.

EBITDA margin

EBITDA = EBIT + depreciation + amortization (plus other operating non-cash charges only if the case says to add them).

EBITDA margin = EBITDA / Revenue.

Harbor: 25%. The four-point gap versus EBIT margin is exactly D&A / Revenue = 5%. If D&A is zero, the two margins coincide. If a capital-intensive plant has D&A equal to 12% of revenue, a 25% EBITDA margin is only a 13% EBIT margin. Saying margins are 25% without naming which margin is an FMVA miss.

Net profit margin

Net profit margin (NPM) = Net income / Revenue.

Harbor: 10,500,000 / 80,000,000 = 13.125%, shown as 13.1%. The drop from a 20% EBIT margin to a 13.1% net margin is interest (2.5% of revenue) and tax (4.4% of revenue). A company with no debt can still have a wide EBIT-to-net gap if the tax rate is high. A company with heavy debt can post a thin net margin even with a healthy EBIT margin.

Net margin is the profitability input to three-step DuPont in the next section. It is not the numerator of ROIC (that is NOPAT) and not the numerator of an EBITDA multiple (that is EBITDA).

Contribution Margin versus Gross Margin

Contribution margin is a managerial-accounting idea. CFI still expects you not to confuse it with GAAP gross margin.

Contribution = Revenue − variable costs.

Contribution margin % = Contribution / Revenue.

Contribution per unit = Price − Variable cost per unit.

Harbor ships 1,600,000 units at a $50 price = $80,000,000 revenue. Variable production cost is $25 per unit = $40,000,000. Fixed manufacturing overhead of $8,000,000 sits inside COGS and is not variable. Ignore variable selling cost for this first cut.

• Contribution = 80,000,000 − 40,000,000 = $40,000,000
• Contribution margin = 40,000,000 / 80,000,000 = 50%
• Contribution per unit = $50 − $25 = $20
• COGS = 40,000,000 + 8,000,000 = $48,000,000
• Gross profit = $32,000,000
• Gross margin = 40%

The 10-point gap is $8,000,000 / $80,000,000. Gross margin treats fixed factory cost as a product cost. Contribution margin does not. If volume falls, contribution margin % can stay 50% while gross margin collapses, because the $8,000,000 of fixed overhead is spread over fewer units.

If Harbor also pays $4,000,000 of variable selling commissions inside SG&A, total variable cost becomes $44,000,000, contribution falls to $36,000,000, and contribution margin is 45%. That 45% is still not 40% gross margin, and it is still not 20% EBIT margin.

Exam trap: dropping contribution margin into a DuPont net-margin slot, or using gross margin as the contribution ratio in a break-even question. Name the cost classification before you divide.

Why EBITDA Is Not Cash

EBITDA starts at accrual operating profit and only adds back D&A. It does not subtract:

• Capital expenditure (capex) needed to maintain or grow the asset base
• Increases in net working capital (NWC) — more receivables and inventory, or fewer payables
• Cash interest
• Cash taxes, which can differ from book tax because of deferred tax
• Debt principal, dividends, and buybacks (financing outflows, but still cash)

Harbor Year 3 bridge from EBITDA toward cash:

Indirect cash from operations (CFO) is the identity you should prefer: net income $10,500,000 + D&A $4,000,000 + deferred tax $300,000 − ΔNWC $3,000,000 = $11,800,000. Subtract capex $6,000,000 and you have $5,800,000 before dividends. Unlevered free cash flow (UFCF) uses NOPAT instead of NI: EBIT × (1 − tax rate) + D&A − capex − ΔNWC = 16,000,000 × 0.75 + 4,000,000 − 6,000,000 − 3,000,000 = $7,000,000. None of those figures is $20,000,000.

EBITDA is a useful starting point and a common valuation statistic. It is not a cash flow statement. A case that treats $20 million of EBITDA as $20 million of cash available to pay down debt will overstate ending cash and understate the revolver.

Traps That Mix Margin Definitions

Memorize this comparison table. FMVA distractors swap the rows.

Six traps that show up as wrong-but-plausible choices:

1. Calling EBITDA margin operating margin.
2. Treating gross margin as contribution margin when COGS includes fixed overhead.
3. Computing net margin as NI / assets (that is ROA) or NI / equity (that is ROE).
4. Mixing a trailing-twelve-month margin with a single quarter that you forgot to leave un-annualized.
5. Adding stock-based compensation back into EBITDA and then treating the result as owner cash — non-cash is not the same as free of cost, because the shares dilute.
6. Comparing a company that classifies factory D&A in COGS with a peer that classifies it in SG&A and calling the gross-margin gap operating performance.

The exam skill is to name the numerator before you interpret the percentage. Vertical analysis already gave you every line as a percent of revenue. Your job is to pick the right line, then use CFI's horizontal formula if the question is about change rather than level.