Profit margin ratios are invaluable when determining a company's overall financial health. These calculations are extremely prevalent in corporate finance but they can also be useful for measuring your company's profitability. In this article, we explain what a profit margin ratio is, explore how to calculate and interpret the results, list the different types of profit margin ratios and provide an example of this concept being put to use.
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What is the profit margin?
Profit margin is the ratio of profit remaining from sales after all expenses have been paid. You can calculate profit margin ratio by subtracting total expenses from total revenue, and then dividing this number by total expenses. The formula is: ( Total Revenue - Total Expenses ) / Total Revenue. Profit margin ratio is shown as a percentage. Other names for profit margin are profit margin ratio, gross profit ratio and sales ratio. A company’s profit margin ratio can show how well the company is managing its overall finances.
A profit margin ratio is often used by investors and creditors to determine a company's ability to convert the profit made from sales into net income. Creditors are interested in these figures so that they can ensure a company makes enough money to repay its loans, while investors are looking for assurance that there is enough profits to be able to distribute dividends. In other words, these external sources are looking for proof that the organization is being run efficiently. In cases where the profit margin is particularly low, it serves as an indication that the company needs to cut back on its expenses by instituting a stricter budget.
How to calculate the profit margin ratio
Though there are three different ways to calculate a company's profit margin ratio, here are the steps for calculation in the simplest form:
1. Calculate the net sales
First, you need to determine the company's net sales by following this formula:
Net sales = revenue - returns, refunds and discounts
2. Determine the net income
Next, you calculate the net income by using this formula:
Net income = revenue - total expenses
3. Find the profit margin ratio
Finally, after calculating the net income and net sales you can find the profit margin ratio by employing this calculation:
Profit margin = (net income / net sales) x 100
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How to interpret the results
The profit margin ratio determines what percentage of a company's sales consists of net income. Put simply, it provides a measurement of how much profits are generated from a company's sales. This number is useful for determining how well an organization's finances are being managed.
Companies strive for higher profit margin ratios which means that their profits will exceed their expenses. They accomplish these higher ratios by either lowering expenses or increasing revenues. Though generating more revenue would be a preferred solution, it is often more difficult than reducing spending budgets. Therefore, most companies cut expenses to improve their profitability.
Additionally, this figure can be used to compare a company's current and past performance as well as to compare similarly-sized companies in the same industry.
Types of profit margins
There are three major levels for calculating a company's profit on its income statement:
- Gross profit margins
- Operating profit margins
- Net profit margins
Gross profit is the most basic level of profit margin, while net profit is the most comprehensive. These financial ratios are both simple and extremely common in corporate finance. Though all three levels differ in their exact method, they all share corresponding profit margins that are found by dividing the profit figure by the company's revenue and then multiplying the result by 100. Here is a deeper look at all three types of profit margins:
Gross profit margins
The gross profit margin is the simplest and most basic way to calculate profitability because it defines profit as any income that is left over after factoring in the cost of goods sold, often referred to as COGS or variable costs.
The cost of goods sold refers to any expense that directly relates to the manufacturing or production of a product, such as the wages paid and raw materials used throughout the process. However, this figure excludes taxes, debt, fixed costs, overhead costs and one-time expenses. Similarly, variable costs are costs that are incurred throughout a process and that can fluctuate with production rates or output. Companies that don't participate in production or manufacturing use the cost of revenue, or the cost necessary to make a sale, instead of variable costs or cost of goods sold.
To calculate the gross profit margin you would need to follow three steps:
1. Calculate the gross profit
You do this by following this equation:
Gross profit = revenue - (direct materials + direct labor + factory overhead)
2. Determining the net sales
You calculate the net sales by following this formula:
Net sales = revenue - cost of sales allowances, returns and discounts
3. Calculate the gross profit margin
You would then find the gross profit margin by following this calculation:
Gross profit margin = (gross profits / net sales) x 100
Operating profit margins
Calculating operating profit margins is slightly more complex than gross profit margins because it accounts for day-to-day business expenses such as sales, administrative, operating and overhead costs. It also includes the depreciation of a company's assets but still excludes non-operational expenses like debts and taxes. This profitability metric divides a company's operating profit by its revenue, giving a clear picture of the percentage of each dollar that is left over after the business's operating expenses are paid for. There are two steps for calculating operating profit margins:
1. Calculate the cost of goods sold
The formula for this is the same regardless of industry. However, the elements involved can vary.
Cost of goods sold = beginning inventory + purchases - final inventory
2. Determine the operating profit margin
You can then calculate the operating profit margin by following this formula:
Operating profit margin = ((revenue + COGS - administrative and selling expenses) / revenue) x 100
Net profit margins
The most complex and comprehensive profitability ratio is the net profit margin. It shows the total revenue left after all income streams and expenses have been accounted for, including COGS and operational expenses. However, unlike the previous two ratios, the net profit margin ratio also takes into account income from investments, one-time payments, taxes and debt. Therefore, this calculation gives an accurate account of a company's overall ability to convert its income into a profit.
There are two steps to determining a company's net profit margin:
1. Calculate the net profit
You find this by following this formula:
Net profit = revenue - (COGS + depreciation + amortization + interest expenses + taxes + other expenses)
2. Determine the net profit margin
To calculate the net profit margin, complete this calculation:
Net profit margin = (net profit / revenue) x 100
Profit margin ratio example
Here is an example of a profit margin ratio being put to use:
Kayla's Cleaning Supplies sells industrial-grade cleaning products to restaurants and bars. Kayla started her business 10 years ago and last year she experienced her best sales yet. Her net sales were $1,000,000 with a net income of $100,000.
Using these figures, here is her profit margin ratio for last year:
10% = ($100,000 / $1,000,000) x 100
As the ratio indicates, Kayla was able to convert 10% of her sales into profits. This year, however, Kayla's net sales were $800,000 with a net income of $200,000. Here is her profit margin ratio for this year:
25% = ($200,000 / $800,000) x 100
Though Kayla made fewer sales, she was able to cut back on her expenses, allowing her to convert more of the sales that she did make into profits.