Knowing the financial health of your company comes with a lot of equations and terms. One that you need to know is “profit margin.” What is it, why does it matter and how do you calculate it? Read on to learn more.
Definition of Profit Margin
The profit margin is the percentage of revenue or sales that is leftover after all costs, taxes, interest, depreciation and any other important expenses have been deducted. Typically, preferred stock dividends are included in this calculation, while common stock dividends are not. [Learn more: preferred stock vs common stock]
Profit margin is one of the simplest – and probably the most widely used – financial ratio used by companies. Another simple way to calculate a company’s profit margin is by dividing the profit by revenue and multiplying by 100.
Profit margin can be applied to gross profit, operating profit and net profit. Each of them has its own corresponding profit margin. Sales should be net sales.
Why Does Profit Margin Matter to a Company?
Profit margin is one of the most important financial numbers that a company can calculate. It is used in a lot of financial comparisons and determinations. However, it’s important to recognize that profit margin will incorporate a lot of noncash elements – depreciation can impact profit margin, as can changes in accounting techniques and methods.
Standard profit margins vary widely between different companies and industries. In addition, some companies seek to minimize their taxes, and thus seek a lower profit margin. In other cases, low profit margin may be indicative of problems. Profit margin cannot be used alone to determine the financial prosperity of a company – many companies face a cyclical trend in their profit margin, and a high or low income is not necessarily correlated to a high or low profit margin.
A company with high profit margin tends to enjoy some type of competitive advantage in the market. This competitive advantage either allows the company to sell its product at a higher price in the market, or it allows the company to produce the product with lower costs compared to the competition.
How to Calculate Net Profit Margin
Profit margin is calculated by using this equation:
Net Profit Margin = (Total Sales – Total Expenses) ÷ Total Sales
Another simple way to calculate it is by using these numbers:
Net Profit Margin = Net Income ÷ Revenue
As mentioned above, profit margin can be calculated for any level of the income – the gross, operating or net income. What numbers and financial documents you use to find the profit margin will be based on which version you are attempting to calculate and what information you are trying to track.
Profit margin is a helpful number, but remember that you need context for it in order to best understand what it indicates.
Calculating Profit Margin: Gross Profit Margin, Operating Profit Margin and Net Profit Margin
When calculating profit margin, you need to know the profit level that you are calculating the margin at. These different profit margins will give you different insights in the business. We will give a brief overview of the 3 types, gross profit margin, operating profit margin and net profit margin.
Gross Profit Margin simply refers to the ratio of gross profits and sales. A company that generates good gross profits does necessarily runs a profitable business as none of the expenses (other than the cost of goods sold) has been accounted for in this yet. A very high cost structure can make the company unprofitable. However, Gross profit margin is a useful indicator to understand if the company is pricing its products appropriately and is able to source from its suppliers in a cost effective manner.
Operating profit margin refers to the ratio of the operating profits and sales. As the name indicates, operating profit margin shows how efficiently the company runs its operations. This does not include costs such as SG&A, financing costs (interest, etc.). Compare the operating profit margins if you want to understand whether the company is running its operations as efficiently as possible.
Net profit margin refers to the ratio of the net income and sales. A good net profit margin indicates a highly profitable company. All the relevant costs in the period have been accounted for in this calculation.
Is Profit and Margin Correlated?
Yes, profit and margin are correlated but you need to take care to consider like with like. For example, net profit is correlated with net profit margin. Gross profit is correlated with gross profit margin. However, a high gross profit does not necessarily mean a high net margin.
This is because different industries and companies have different operating structure. This means that the operating costs, employee expenses, etc. can be remarkably different. Grocery stores can have quite high gross profit but by the time they sell the product to the consumer, a good chunk of the gross profit is eaten up by distribution, and selling costs and the resulting net profit margin is razor thin.
Also keep in mind that while a company wants to increase its revenue over time, this does not necessarily mean that the company is increasing its profit at the same time. If the expenses rise faster, the net profit margin will go down. If the expenses rise high enough, it is quite possible that the company can move from profit to loss at higher level of revenue. While this can be distressing, it may also be a necessary investment in scaling the business up. Later the company can figure out ways to cutting expenses and increasing profit.
Can Profit Margin be too High?
Profit margin has to be less than 100% unless there are extraordinary situations (a company with no operations/costs wins a lawsuit or sells their patents, etc.). Given that 100% sets the upper limit for profit margin, how high can it really be in real world?
There are high net profit margin businesses and there are low net profit margin businesses. Economic theory suggests that any industry with high profit margins will see an influx of new entrants over time. As competition increases, the profit of all the players in the market is driven down. In the extreme case of a perfectly competitive market (where no one company is able to set price), the profit and the net profit margin for each competitor approaches zero.
It follows that the key to maintain high profit margin is to limit competition in the market. There are many ways this can be done. Setting up a monopoly or a duopoly can be very lucrative and lets the existing players enjoy high margins. Taken too far can result in antitrust measures being applied on the firms engaging in these practices. A company can also engage in predatory pricing, exclusionary deals, etc. to drive the competitors out of the market. Once done, they can then raise prices and enjoy high profit margins. Regulations exist to protect consumers against such practices.
The best way to maintain high profit margin without getting caught up in the regulatory tangles is to differentiate your product or service from others in a manner that is not easily copied. For example, a company may invest heavily in building a strong brand, and the brand recognition means consumers may be willing to pay higher for their products. In a reasonably well functioning and competitive market such as US, high profit margin is typically correlated with some type of sustained competitive advantage.
How high is a high profit margin? We would think that any net profit margin above 20%-25% is very strong. Anything above 50% and you are in the nose-bleed category and is highly unlikely to be sustained.