A simple definition of profit margin

Profit margin is a pretty simple financial metric to understand even for those who may not have expert knowledge of corporate finance. Simply put, the profit margin is the percentage of the value of sales that gets converted into profits. As we already know, the entire revenue generated from sales is not profit because the cost price of goods and services plus other expenses also need to be accounted for while calculating profits.

Analysts can look at profit margin in terms of the profits earned by a business or investment for every dollar of sales. So, for instance, let’s say the profit margin of an enterprise in a financial period is 40 percent. It implies that for every dollar of sales in that fiscal period, the company earned a profit of \$ 0.40.

Profit margin, being an effective measure of corporate financial performance, is used by financial analysts, investors, and creditors to assess the current performance and future growth prospects of a business. Also, the profit margin can be looked at as an essential indicator of a company’s financial management and scalability to attract investors. Needless to say, profitability is a direct and one of the most vital measures of business success.

Probing further, there are different classifications of profit margin that are used for financial analysis subject to the purpose and approach being taken. The subsequent section discusses the various types of profit margins along with the formulas for their calculation.

Types of profit margin with formulas

1. Net profit margin

Among all types of profit margins, the net profit margin is considered the most significant profit margin for assessing the profitability scenarios of an organization. Net profit margin can be defined as the ratio between net profits and net sales generated by a business during a specific time period. Alternatively, the net profit margin can also be the ratio between a company’s net income and the generated revenue.

Here it is notable that in profit margin calculations, net income and net profit can be used interchangeably. Also, in the same context, sales and revenue can also be used interchangeably. For calculating net profit, from the total revenue generated in a financial period all costs inclusive of operating expenses, rental expenses, labor costs, cost of raw materials etcetera are subtracted.

The formula for the calculation of net profit margin is given below.

a. Basic formula for calculating profit margin

 Profit Margin = Net profit/income Net sales/revenue

b. Formula for calculating net profit margin

 Net profit margin = (R-COGS-OE-0-I-T)X100 R

Where

R: Revenue

COGS: Cost of Goods Sold

OE: Operating expenses

O: Other expenses

I: Interest payments

T: Taxes

To exemplify, let us say the total revenue generated by a company during a fiscal period is USD 200, 000 and the incurred expenses (inclusive of all elements) are worth USD 160,000.

As per the formula, net profit margin with be 20 percent

2. Gross profit margin

To begin with, gross profit is defined as the profit that a business generates after the subtraction of the Cost of Goods Sold (COGS) from the generated revenue. In an interchangeable way, gross profit can be alternatively used with the terms sales profit and gross income. The gross profit margin is an expression of gross profit earned by a company in terms of a profitability ratio.

The formula for calculating gross profit margin is given below

 Gross profit margin = Net sales - COGS X100 Net sales

Where

COGS: Cost of goods sold

To exemplify, let’s say the net sales generated by a company in a financial period are worth \$ 500,000, and the COGS account for \$ 325,000. As per the formula, the gross profit margin will come out to be 35 percent.

3. Operating profit margin

The operating profit of an enterprise represents the overall earnings from the core operations of a business with the exclusion of interest and tax deductions. Besides, profits from ancillary investments are also excluded. The operating profit margin is also referred to as the earnings generated before interests and taxes. It is calculated by deducting the operating expenses of a company from the company’s profits

From the perspective of financial analysis, operating profit margin is a key metric for evaluating a company’s financial condition for potential buyouts. The formula for calculating operating profit margin is given below

 Gross profit margin = Operating incomeX100 Revenue

For instance, assuming that the operating income of an organization in a financial period is \$ 225,000 and the total revenue generated by the organization corresponding to the same period is worth \$ 850,000. In this case, the operating profit margin as per the above formula will be 26.4 percent.

4. Pretax Profit Margin

Pretax profit margin refers to the profit margin made by a company on its sales before the deduction of taxes. Pretax profit margin gives a direct measure of an enterprise’s operating efficiency in terms of generating profitability. To augment, pretax profit is an important financial accounting metric that can be effectively used to draw comparisons between the profitability of different companies within the same industry.

Further, the pretax profit margin is calculated by deducting the interest expenses and operating expenses from the gross profit of the organization. Pretax earnings are also referred to as EBT (earnings before taxes). The formula for the calculation of pretax profit margin is provided below.

 Pretax Profit Margin = Pretax earnings (operational profit-interest)X 100 Total sales in the fiscal period

So, if we consider an example, let’s say a company’s pretax earnings in a financial period come out to be worth \$ 625, 000 while the total value of sales in that period is \$12,50,000. As per the formula, the pretax profit margin will be 50 percent.

5. EBIT Ratio

EBIT is an acronym for earnings before interest and taxes. EBIT is a direct indicator or metric of an organization’s efficiency to generate profits. Further, EBIT is also referred to as operating earnings or operating profits as the interest payments and tax payments are excluded from EBIT.

The formula to calculate the EBIT ratio is given below

 EBIT Ratio = (net income - interest - taxes) Revenue

Significance of profit margin calculations

Profit margin is one of the key figures featured in the quarterly financial results reported by business organizations. Besides, the profit margin is a universally accepted measure of companies’ profit generating capabilities and is a direct indicator of their financial efficiency. Also, companies can effectively use profit margin as an internal measure of their operating efficiency or for addressing problem areas in operations. To explain, the profit margin and operating expenses have an inverse relationship and hence, for higher profitability, it becomes essential for a business to address operating inefficiencies.

Also, companies can look at their competitor’s profit margin as a key metric for competitor analysis in the industry. Also, when companies are looking for funding, they need to pitch their financial performance to the investors and in that context, profit margin proves to be one of the most important key performance indicators among different financial ratios.

As mentioned above, among different profit margin ratios, the net profit margin is the most significant of all for comparing businesses subject to their financial valuation. While comparing companies in the same industry, the net profit margin is used as a key metric from the analysis viewpoint. Having said that, it can be said that profit margin ratios are among the most crucial financial metrics in corporate finance. With the help of these ratios, even people from non-finance backgrounds can easily evaluate the financial profitability of businesses.

Some industries with the highest profit margins

As per Yahoo Finance, some of the industries with the highest profit margins are listed below (in no particular order)

• Information services
• Semiconductor manufacturing
• Food processing industry
• Soft beverages industry
• Pharmaceutical industry
• Software industry
• Healthcare
• Oil and gas
• System applications
• Insurance