Understanding Profit Margin. http://www.MDTSeminar.com
Profit margin is part of a category of profitability ratios calculated as net income divided by revenue, or net profits divided by sales. Net income or net profit may be determined by subtracting all of a company’s expenses, including operating costs, material costs (including raw materials) and tax costs, from its total revenue. Profit margins are expressed as a percentage and, in effect, measure how much out of every dollar of sales a company actually keeps in earnings. A 20% profit margin, then, means the company has a net income of $0.20 for each dollar of total revenue earned.
While there are a few different kinds of profit margins, including “gross profit margin,” “operating margin,” (or "operating profit margin") “pretax profit margin” and “net margin” (or "net profit margin") the term “profit margin” is also often used simply to refer to net margin. The method of calculating profit margin when the term is used in this way can be represented with the following formula:
Profit Margin = Net Income / Net Sales (revenue)
Other types of profit margins have different ways of calculating net income so as to break down a company’s earnings in different ways and for different purposes.
Profit margin is similar but distinct from the term “profit percentage,” which divides net profit on sales by the cost of goods sold to help determine the amount of profit a company makes on selling its goods, rather than the amount of profit a company is making relative to its total expenditures.
Rarely can a company’s individual numbers (like revenue or expenditures) indicate much about the company’s profitability, and looking at the earnings of a company often doesn't tell the entire story. Increased earnings are good, but an increase does not mean that the profit margin of a company is improving.
Profit margin is a useful ratio and can help provide insight about a variety of aspects of a company’s financial performance.
On a rudimentary level, a low profit margin can be interpreted as indicating that a company’s profitability is not very secure. If a company with a low profit margin experiences a decline in sales, its profit margin will decline even further, leading to a very low, neutral or even negative profit margin.
Low profit margins may also reveal certain things about the industry in which a company operates or about broader economic conditions. For example, if a company’s profit margin is low, it may indicate that it has lower sales than other companies in the industry (a low market share) or that the industry in which the company operates is itself suffering, perhaps because of waning consumer interest (or increasing popularity and/or availability of alternatives) or because of hard economic times or recession.
Profit margin may also indicate certain things about a company’s ability to manage its expenses. High expenditures relative to revenue (i.e. a low profit margin) may indicate that a company is struggling to keep its costs low, perhaps because of management problems. This is an indication that costs need to be under better control. High expenditures may occur for many reasons, including that the company has too much inventory relative to its sales, that it has too many employees, that it is operating in spaces that are too large and thus is paying too much in rent, and for many other reasons. On the other hand, a higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors.
Profit margin can also illuminate certain aspects of a company’s pricing strategy. For example, a low profit margin may indicate that a company is underpricing its goods.
Though profit margin is a helpful and popular ratio for gauging a company’s profitability, like any financial metric or ratio it comes with certain accompanying limitations that any investor should consider when considering a company’s profit margin.
While profit margin can be very useful for comparing companies with one another, one should only use profit margin to compare companies within the same industry, and ideally with similar business models and revenue numbers as well. Companies in different industries may often have wildly different business models, such that they may also have very different profit margins, thereby rendering a comparison of their profit margins relatively meaningless.
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