Hi Sruthi,
Thanks for asking this question. I believe the answer is DSCR.
I however have an inkling that the question might have been set with a different context. They might have suggested that
Hi Sruthi,
Thanks for asking this question. I believe the answer is DSCR.
I however have an inkling that the question might have been set with a different context. They might have suggested that Operating margin is an outcome of profitability, and it doesn’t “drive” profitability whereas Inventory Turnover ratio being an activity ratio and DSCR showing the level of Debt and associated availability of Capital might drive profitability. this is a stretch explanation and not the one I would choose.
Now Let’s look at how we could approach this in a normal manner:
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Operating Margin: This ratio, calculated as operating income divided by revenue, measures the percentage of revenue left after covering operating expenses (e.g., cost of goods sold and operating costs, excluding interest and taxes). It directly reflects how efficiently a firm manages its core business operations to generate profit. Thus, Operating Margin is a clear determinant of profitability.
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Inventory Turnover Ratio: This ratio, calculated as cost of goods sold divided by average inventory, indicates how quickly a firm sells and replaces its inventory. It’s primarily a measure of operational efficiency and liquidity, showing how well a firm manages its inventory to support sales. While efficient inventory management can indirectly support profitability by reducing holding costs or enabling sales, it doesn’t directly measure profit generation. Its impact on profitability is secondary, as it influences costs rather than directly determining earnings.
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Debt Service Coverage Ratio (DSCR): This ratio, calculated as operating income divided by total debt service (principal and interest payments), assesses a firm’s ability to cover its debt obligations with its operating income. It’s a solvency metric, focusing on financial stability and creditworthiness rather than profitability. While high debt levels (and thus a low DSCR) could indirectly reduce profitability due to interest expenses, DSCR itself doesn’t directly measure or determine profit—it evaluates debt repayment capacity.
In ratio analysis, profitability is most directly tied to metrics that quantify earnings relative to sales, assets, or equity. Operating Margin fits this category as a core profitability ratio. Inventory Turnover Ratio, while important for efficiency, is typically classified under activity or efficiency ratios, with an indirect link to profitability.
Debt Service Coverage Ratio, however, is a solvency ratio, focused on debt management rather than profit generation, making it the least directly tied to profitability.
Therefore, the ratio not directly considered a determinant of a firm’s profitability is the Debt Service Coverage Ratio.
Hope this helps.
Madhu Chandarasekaran, CFA.
Sruthi J
In the context of evaluating a firm’s financial performance using ratio analysis, which of the following is NOT directly considered a determinant of the firm’s profitabilityMadhu Chandarasekaran, CFA
Hi Sruthi,