Understanding Profit Margin

Profit Margin

gauge the degree to which a company or a business activity makes money. It represents what percentage of sales has turned into profits. Simply put, the percentage figure indicates how many cents of profit the business has generated for each dollar of sale. For instance, if a business reports that it achieved a 35% profit margin during the last quarter, it means that it had a net income of $0.35 for each dollar of sales generated.

There are several types of profit margin. In everyday use, however, it usually refers to net profit margin, a company’s bottom line after all other expenses, including taxes and one-off oddities, have been taken out of revenue.

Understanding Profit Margin

The Basics of Profit Margin

Businesses and individuals across the globe perform for-profit economic activities with an aim to generate profits. However, absolute numbers—like $X million worth of gross sales, $Y thousand business expenses or $Z earnings—fail to provide a clear and realistic picture of a business’ profitability and performance. Several different quantitative measures are used to compute the gains (or losses) a business generates, which make it easier to assess the performance of a business over different time periods, or compare it against competitors. These measures are called profit margin.

While proprietary businesses, like local shops, may compute profit margins at their own desired frequency (like weekly or fortnightly), large businesses including listed companies are required to report it in accordance with the standard reporting timeframes (like quarterly or annually). Businesses which may be running on loaned money may be required to compute and report it to the lender (like a bank) on a monthly basis as a part of standard procedures.

There are four levels of profit or profit margins: gross profit, operating profit, pre-tax profit, and net profit. These are reflected on a company's income statement in the following sequence: A company takes in sales revenue, then pays direct costs of the product of service. What’s left is gross margin. Then it pays indirect costs like company headquarters, advertising, and R&D. What’s left is operating margin. Then it pays interest on debt and adds or subtracts any unusual charges or inflows unrelated to the company’s main business with pre-tax margin left over. Then it pays taxes, leaving the net margin, also known as net income, which is the very bottom line.

KEY TAKEAWAYS

Profit margin gauges the degree to which a company or a business activity makes money, essentially by dividing income by revenues.

Expressed as a percentage, profit margin indicates how many cents of profit the business has generated for each dollar of sale.

While there are several types of profit margin, the most significant and commonly used is to net profit margin, a company’s bottom line after all other expenses, including taxes and one-off oddities, have been removed from of revenue.

Profit margins are used by creditors, investors, and businesses themselves as indicators of a company's financial health, management's skill, and growth potential.

As typical profit margins vary by industry sector, care should be taken when comparing the figures for different businesses.

Types of Profit Margin

Let's look more closely at the different varieties of profit margins.

Gross Profit Margin

Gross profit margin: Start with sales and take out costs directly related to creating or providing the product or service like raw materials, labor, and so on—typically bundled as "cost of goods sold,” “cost of products sold,” or “cost of sales” on the income statement—and you get gross margin. Done on a per-product basis, gross margin is most useful for a company analyzing its product suite (though this data isn’t shared with the public), but aggregate gross margin does show a company’s rawest profitability picture. As a formula:

Gross Profit Margin formula

Gross Profit Margin formula. Investopedia

Operating Profit Margin

Operating Profit Margin (or just operating margin): By subtracting selling, general and administrative, or operating expenses, from a company's gross profit number, we get operating profit margin, also known as earnings before interest and taxes, or EBIT. Resulting in an income figure that’s available to pay the business' debt and equity holders, as well as the tax department, it's profit from a company’s main, ongoing operations. it’s frequently used by bankers and analysts to value an entire company for potential buyouts. As a formula:

Operatng profit margin formula

Pretax Profit Margin

Pretax profit margin: Take operating income and subtract interest expense while adding any interest income, adjust for non-recurring items like gains or losses from discontinued operations, and you’ve got pre-tax profit, or earnings before taxes (EBT); then divide by revenue, and you've got the pretax profit margin.

The major profit margins all compare some level of residual (leftover) profit to sales. For instance, a 42% gross margin means that for every $100 in revenue, the company pays $58 in costs directly connected to producing the product or service, leaving $42 as gross profit.

Net Profit Margin

Let's now consider net profit margin, the most significant of all the measures—and what people usually mean when they ask, "what's the company's profit margin?"

Net profit margin is calculated by dividing the net profits by net sales, or by dividing the net income by revenue realized over a given time period. In the context of profit margin calculations, net profit and net income are used interchangeably. Similarly, sales and revenue are used interchangeably. Net profit is determined by subtracting all the associated expenses, including costs towards raw material, labor, operations, rentals, interest payments, and taxes, from the total revenue generated.

Mathematically, Profit Margin = Net Profits (or Income) / Net Sales (or Revenue)

= (Net Sales - Expenses) / Net Sales

= 1- (Expenses / Net Sales)

Or as a formula:

Net Profit Margin Formulas