Profit margins are a major focus for shareholders and management across every industry, and can be one of the best financial indicators of a company's success. High profit margins can increase the price of stocks and determine the bonus awarded to managers. Profit margins are critical indicators of health for businesses both large and small.
What is a Profit Margin?
Profit is what is left of revenues after expenses are paid. A profit margin is a ratio used to assess the profitability of a business or activity. On a basic level, a profit margin represents the ratio of sales that have been converted into profit after expenses, according to AccountingTools. This is commonly represented by the amount in cents of profit per dollar of revenue. Since a profit margin is represented by a percentage, a 15 percent profit margin would equate to 15 cents of profit per single dollar. The net profit margin is generally accepted as the foremost profit margin when considering the general profitability of a business.
Profit margin ratios use gross, operating and net profit information to generate a percentage. Each of these areas of profit can be found on a company income statement and can be used to generate a margin percentage with a simple formula. For example, the net profit margin can be calculated like this: Net Profit Margin = (Net Income / Revenue) * 100. If a business has $50,000 in net income and $100,000 in revenue, its net profit margin would be 50 percent.
The primary profit margin ratios commonly used to determine the profitability of a company include gross profit, net profit and operating profit. These three profit margins provide insight into unique areas across the business when examined in tandem, they provide a comprehensive overview of business profitability and overall health.
What is the Gross Profit Margin?
Gross profit is one of the simplest measures of profitability and not typically used alone in reviewing the full viability of a business. It is the first part of an income statement. Gross profit is total revenue with the cost of goods sold (COGS) subtracted. The result is a residual margin that is left to pay for administrative and other costs. The gross profit margin is always larger than the net profit margin because it does not reflect as many expenses as the net profit margin. The gross profit margin will also include more variable expenses directly related to selling. It can be used to determine which items are the most and least profitable.
Formula for calculating the gross profit margin: Gross Profit Margin = (Gross Profit / Revenue) x 100
What is the Operating Profit Margin?
Operating profit will comprise the second part of an income state. Operating profit includes revenue with COGS and operating costs deducted. This margin will only reflect earnings from operations. The operating profit margin will express how well a company is able to manage indirect costs. Operating expenses are an area that management has more control over than other areas. Operating profit is also known as EBIT, or earnings before interest and taxes. Operating profit reflects how well the business operates and generates income before taxes and interest are deducted, expenses that are not based on company performance, according to the Business Literacy Institute.
Formula for calculating the operating profit margin: Operating Profit Margin = (Operating Profit / Revenue) x 100
What is the Net Profit Margin?
Net income is considered the bottom line for a company. It is the final component when analyzing an income statement. This is the revenue that is left after accounting for all income and expenses. The net profit margin indicates a company's capability to convert income into profit and is typically considered foremost when analyzing overall profitability. Net profit will reflect more fixed costs than the gross profit and will include EBIT expenses. A good net profit margin is 20 percent, according to the Corporate Finance Institute, while 10 percent is average and 5 percent is low.
Formula for calculating the operating profit margin: Net Profit Margin = (Net Income / Revenue) * 100