Let’s face it, the most important goal of a business is to make money and keep it, which depends on liquidity and efficiency. Since these characteristics determine a company’s ability to pay a dividend to investors, profitability is reflected in the stock price.
That’s why investors need to know how to analyze the different facets of profitability, including how efficiently a company uses its resources and the revenue it generates from its operations. Knowing how to calculate and analyze a business profit margin is a great way to better understand how well a business generates and retains money.
Key points to remember
- Investors who know how to calculate and analyze a business profit margin gain insight into a company’s current efficiency in generating profits and its potential to generate future profits.
- The three main profit margin ratios investors should look at when evaluating a business are gross profit margins, operating profit margins, and net profit margins.
- Companies with large profit margins often have a competitive advantage over other companies in their industry.
- Understanding a company’s margin ratios can be a starting point for further analysis to decide if a company would be a good investment option.
Analyzing Business Profit Margins Using Profit Margin Ratios
It’s tempting to rely solely on net profits to gauge profitability, but that doesn’t always paint a clear picture of a business. Using it as the sole measure of profitability can be a bad idea.
Profit margin ratios, on the other hand, can give investors deeper insight into management effectiveness. But instead of measuring how much a business earns from its assets, equity, or invested capital, these ratios measure how much money a business makes from its total revenue or total sales.
Margins are profits expressed as a ratio or percentage of sales. A percentage allows investors to compare the profitability of different companies, while net profits, which are presented as an absolute number, do not.
Profit Margin Ratio Example
Suppose Company A had annual net income of $749 million on sales of about $11.5 billion last year. Its main competitor, Company B, earned about $990 million for the year on sales of about $19.9 billion. Comparing Company B’s net profit of $990 million to Company A’s $749 million shows that Company B earned more than Company A, but that doesn’t tell you much about profitability.
However, if you look at the net profit margin or the revenue generated by each dollar of sales, you will see that company A produced 6.5 cents on every dollar of sales, while company B brought in less than 5 cents.
There are three main profit margin ratios: gross profit margins, operating profit margins, and net profit margins.
Gross margin
Gross profit margin tells us how much profit a business makes on its cost of sales, or cost of goods sold (COGS). In other words, it indicates how efficiently management uses labor and supplies in the production process. This is the formula:
Gross Profit Margin = (Sales – Cost of Goods Sold)/Sales
Suppose a company has $1 million in sales and the cost of its labor and materials is $600,000. Its gross margin rate would be 40% (($1M – $600,000)/$1M).
Companies with high gross margins will have money to spend on other business operations, such as research and development or marketing. When analyzing company profit margins, look for declining trends in gross margin rate over time. This is a telltale sign that the company could have future problems with its results.
For example, businesses often face rapidly rising labor and material costs. Unless the company can pass these costs on to customers in the form of higher prices, these costs could reduce the company’s gross profit margins.
It is important to remember that gross profit margins can vary widely from company to company and industry to industry. For example, the software industry has a gross margin of around 90%, while the airline industry only has a gross margin of around 5%.
Operating profit margin
By comparing earnings before interest and taxes (EBIT) to sales, operating profit margins show how successful a company’s management has been in generating revenue from the operation of the business. Here is the calculation:
Operating profit margin = EBIT/sales
If EBIT was $200,000 and sales were $1 million, the operating profit margin would be 20%.
This ratio is an approximate measure of the operating leverage a company can achieve in the operational part of its business. It indicates how much EBIT is generated per dollar of sales. High operating profits can mean that the company is effectively controlling its costs or that sales are growing faster than operating costs.
Knowing operating profit also allows an investor to make profit margin comparisons between companies that do not release separate disclosure of their cost of goods sold figures.
Operating profit measures how much money the business makes, and some consider it a more reliable measure of profitability because it’s harder to manipulate with accounting tricks than net profit.
Naturally, since the operating profit margin takes into account administration and selling expenses as well as materials and labor, it should be much lower than the gross margin.
The net profit margin
Net profit margins are those generated by all phases of a business, including taxes. In other words, this ratio compares net profit to sales. This comes as close as possible to summing up in a single number how effectively leaders run a business:
Net profit margins = Net profit after tax/sales
If a company generates $100,000 after-tax profit on $1 million in sales, its net margin is 10%.
To be comparable from company to company and from year to year, net profits after tax should be presented before deduction of minority interests and adding income from equity. Not all companies have these items. In addition, investment income, which is entirely at the whim of management, can change significantly from year to year.
Like gross and operating profit margins, net margins vary from industry to industry. By comparing a company’s gross and net margins, we can get a good idea of its non-production and non-direct costs, such as administrative, financial and marketing costs.
Net Profit Margin Examples
The international airline industry has a gross margin of only 5%.Its net margin is just a bit lower, at around 4%.On the other hand, budget airlines have much higher gross and net margins. These differences provide insight into their distinct cost structures. Compared to its larger cousins, the budget airline industry spends proportionally more on finance, administration and marketing, and proportionally less on fuel and crew salaries.
In the software industry, gross margins are very high while net profit margins are considerably lower. This shows that marketing and administration expenses in this industry are very high, while selling costs and operating costs are relatively low.
When a company has a high profit margin, it usually means that it also has one or more advantages over its competitors. Companies with high net profit margins have a greater cushion to protect themselves during difficult times. Companies whose profit margins reflect a competitive advantage can improve their market share during tough times, leaving them even better positioned when things improve.
The essential
Margin analysis is a great tool for understanding business profitability. It tells us how much profit effective management can make from sales and how much leeway a business has to weather a downturn, fend off competition, and make mistakes. But, like all ratios, margin ratios never provide perfect information. They are only as good as the timeliness and accuracy of the financial data entered into them. A correct analysis also depends on taking into account the sector of activity of the company and its position in the economic cycle.
Margin ratios highlight companies that deserve closer scrutiny. Knowing that a company has a gross margin of 25% or a net profit margin of 5% does not tell us much. As with any ratio used alone, margins tell us a lot, but not everything, about a company’s prospects.