At the most basic level, a profit margin is how much a company has left over after paying for its expenses expressed as a percentage. Understanding the margins in any business is important because a fluctuation in margins reflects underlying changes in the fundamentals of the business.
Example -
A business with an income of $100,000 and expenses of $70,000 is left with a Profit of $30,000 (Revenue - Expenses = Profit). The profit margin is calculated by using a very simple formula:
Profit Margin = [ Profit / Revenue ] x 100
Profit Margin = [ $30,000 / $100,000 ] x 100
= 30%
This means that 30% of the revenue the business generates turns into a profit.
The Importance of Profit Margins
Knowing a company's profit margin can be helpful in a number of ways. They can be used to
Let's say Superpower Inc. has Margins of 30% and its top competitor Villains Inc. has margins of 20%. It would be pretty safe to say that Superpower Inc. is operating more efficiently since it has a higher percentage of revenue coming in that's being saved as Profits.
Investors are always looking to find good investments for themselves. Investigating Profit Margins gives investors deeper insights into a business compared to analyzing profit alone.
Let's say a tech company has a Profit left over at the end of the year of $600,000 and a soft drink maker has a Profit leftover of $600,000 as well. An investor can get an understanding of which investment is better by investigating the margins of each business.
If the investor sees that the tech company had a Revenue of $1,000,000 and Expenses of $400,000 to make a profit of $600,000 the margin would be 60% (Profit/Revenue) x 100
If the Softdrink manufacturer had a Revenue of $5,000,000 and Expenses of $4,400,000 with the profit leftover as $600,000, it would have a Margin of 12% (Profit/Revenue) x 100.
All other things being equal, astute investors would pick the business with the higher Margin for an investment.
Seeing profits as a percentage instead of a number can aid in understanding the performance of a company better.
For example, when comparing two companies in similar industries, one with a profit of $4,753,418 and one with a profit of $6,784,289, it's easier to compare the margins of 24% vs. 36% to give us a clearer picture of how the company is performing.
Technical Stuff
You will get a much clearer understanding of how Profit Margins work if you understand the basic structure on an Income Statement. If you need a quick refresher, check out my article on the Income Statement.
Types of Profit Margins
Analysts take the Income Statement and divide the income statement up to report three kinds of Margins. Each type of Margin gives a different perspective on the business. They are
Gross Profit Margins
As we move down the Income Statement, the first expense that gets reported is the Cost of Goods Sold (COGS). COGS is the first expense item since it relates directly to the manufacturing of the product or delivering the service. Taking Revenue and deducting the COGS number gives us the Gross Profit.
Applying the formula we have seen above, we can calculate Gross Margin as follows-
Gross Margin = [ Gross Profit / Revenue ] x 100.
Example of calculating the Gross Profit Margin
Let's say a company makes $25M in Revenue and has $12.5M in COGS.
The Gross Profit can be calculated by
Gross Profit = Revenue - COGS
Gross Profit = $25M - $12M
= $13M
Using the formula for Gross Margin stated above, we get
Gross Margin = [ Gross Profit / Revenue ] x 100
Gross Margin = [ $13M / $25M ]
= 52%
Operating Profit Margins
A company has many different types of expenses and a large chunk of company expenditure goes into keeping the company afloat by paying bills, rent, utilities, etc. Such expenses are called Operating Expenses and are reported after the Gross Profit line in the Income Statement.
The profit left over after deducting the operating costs of the company is called Operating Profit and the same can be expressed as a percentage which is called Operating Profit Margin.
The best way to understand this is by continuing our example of Superpower Inc.
By now we know that the Gross Profit of the company is $13M. If operating expenses in the company amounted to $9M, the Operating Profit would be $13M - $9M = $4M.
We can now calculate the Operating Profit Margin by applying the formula
Operating Profit Margin = [ Operating Profit / Revenue ] x 100
= [ $4M / $25M ] x 100
= 16%
Net Profit Margins
While it is very important for business owners and investors alike to
understand ALL the margin calculations, an argument could be made that the Net Profit Margin is the most important of the three.
The Net Profit in a company is often referred to as the bottom line and the buck truly stops here. The Net Profit is calculated after deducting ALL expenses of the business including the non-operating expenses such as interest costs and taxes.
Continuing our example from above let's say the business had an Operating Profit of $4M and Non-Operating Expenses (Interest & Taxes) totaling $3M. In this case, we would take the Operating Profit of $4M and minus the non-operating profit of $3M and come up with a Net Profit of $1M.
The Net Profit Margin can be calculated as follows
Net Profit Margin = [ Net Profit / Revenue ] x 100
= [ $1M / $25M ] x 100
= 4%