What is a Profit Margin?
In the field of finance and accounting Profit margins are the measure of a firm’s profits (or profits) relative to revenue. The three most important indicators of profit margin include Gross Profit Margin (total revenue plus COGS), cost of good sold (COGS) ), operating profit margin (revenue without COGS and operating costs) as well as the net margin (revenue less all expenses, which includes taxes and interest). This guide will provide the formulas and explanations and an Excel template to determine the figures on your own.
Profit Margin Formula
In assessing the financial viability of a business, There are three main margin ratios that should be considered: operating, gross, and net. Below is a breakdown for the formulas for profit margins.
Gross Profit Margin = Gross Profit / Revenue x 100
Operating Profit Margin = Operating Profit / Revenue x 100
Net Profit Margin = Net Income / Revenue x 100
Profit Margin Example
Let’s look at an example using the formulas that are shown above. XYZ Company is in the online retail industry and offers custom-printed T-shirts. The profit from the sale of shirts in 2018 is $700k. The price of the merchandise sold (the direct cost for producing the shirt) is $200k. The remaining operating expenses (such as selling general administrative (SG&A) interest, tax and interest) total $400k. Calculate the net and gross profit margins of XYZ Company in 2018.
Revenue of $700,000
($200,000) the cost for the goods sold
Gross profit of $500,000
($400,000) Other expenses
$100,000 net income
Based on the income statement numbers Based on the above income statement figures, the following questions can be answered:
The gross margin is equal to $500k gross profits divided by $700k revenue, which is equivalent to 71.4 percent.
Net margin is the net profit divided by 700k revenue, which is 14.3 percent.
What is a Good Profit Margin?
Perhaps you are wondering, “what is a good profit margin?” A decent margin can differ according to industry, however, as a standard that a Net Profit Margin is thought to be average, while a 20 percent margin is considered to be excessive (or “good”), and a margin of 5% is considered to be low. The guidelines for profit margins differ widely based on the industry and size of the business and are affected by a myriad of other variables.
Profit Margin Formula Excel (and Calculator)
Below is a picture from CFI’s Profit Margin Excel calculator. You can see in the image it is an Excel spreadsheet that lets you input different assumptions over five years. The cells with blue text and light gray shading may be used to input your own data. All cells that have dark black fonts are considered formulas, and do not need to be changed.
You can observe in the picture when you input the revenue of a business, its cost of selling goods, and any other operating costs, you will be able to calculate the Margins for Gross Profit EBITDA Net Profit, and EBITDA. EBIT (earnings before taxes and interest) will be the identical to Operating Profit. EBITDA is a little more precise and closer to Net Profit.
Types of Profit Margin
Let’s take a closer look at the various kinds of profit margins.
Gross Profit Margin
Margin for gross profits: Begin with sales, and then subtract expenses directly related to the creation or delivering the item or service, like raw materials, labor and so on. These costs are usually bundled under “cost of goods sold,” “cost of products sold,” or “cost of sales” on the income statement. This gives you a gross margin. Based by-product, gross margin is the most valuable to a business looking at its product portfolio (though this information isn’t available with the general public). However, the overall gross margin can reveal the company’s most complete profitability picture. It is a formula that says:
\begin &\textit=\frac\\ &\textbf\\ &\textit=\text \endGross profit margin=Net sales net sales – COGSwhere:COGS=cost of goods sold
Operating Profit Margin
Operating Profit Margin (or operating margin) When we subtract general and administrative expenses or operating costs from the gross profit and calculating the operating profit margin, which is also called earnings before interest and taxes or EBIT. It gives us an income figure which can use to pay the company’s debt and equity holders and also to the department of taxation, this is a profit from the company’s primary operating activities. It is often used by analysts and bankers to evaluate the value of a company in the event of a buyout. It’s a formula that:
Pretax Profit Margin
Pretax profit margin: Take operating earnings, subtract interest expense, and add any interest income. Adjust for non-recurring expenses like losses or gains of discontinued business operations. Now you’ll have profits before tax, or earnings before tax (EBT). Then, divide the revenue by, and you’ll have the profit margin before tax.
The primary profit margins all measure a certain amount in residual (leftover) profits to sales. For example, an average gross margin implies you pay for $100 of revenues, the company has to pay $58 in direct costs related to the production of the item or service and then earns $42 in gross profit.
Net Profit Margin
Let’s look at net profit margins, the most important metrics. It is also what people typically think of when they ask “what’s the company’s profit margin?”
Profit margins for net profits are calculated by dividing net profit by net sales or dividing the net income by the revenue earned over a specific period. In the case of profit margin calculations, net profit and income are both used interchangeably. Similar to sales and revenue, they are utilized interchangeably. Net profit is calculated by subtracting all expenses, including the cost of raw materials, labor, rental, operations, interest payments, and taxes from the total revenue earned.
Mathematically, Profit Margin = Net Profits (or Income) / Net Sales (or Revenue)
= (Net Sales – Expenses) / Net Sales
= 1- (Expenses / Net Sales)
Using Profit Margin
From a billion-dollar publicly-traded company to a typical Joe’s street hot dog stand The profit margin number is extensively used and quoted by all sorts of companies around the world. In addition to individual companies, they also use it to gauge the potential profitability of larger industries and the overall regional or national market. It is not uncommon to see headlines that read “ABC Research warns on declining profit margins of American auto sector,” or “European corporate profit margins are breaking out.”
In essence, it is the margin of profit that has been the internationally used standard measurement of the profitability-generating capacity of businesses and is a high-level indicator of the potential.
In the internal environment, business management, the owners of the company as well as external consultants utilize it to tackle operational problems and for studying the patterns of seasonality and performance in various time frames. A negative or zero profit margin can result in businesses having difficulty managing their costs or failing to make excellent sales. Another drill-down can help find the leaky areas, like excessive inventory that is not sold, but under-utilized resources and employees and high rental rates. They then create appropriate plans for action. Enterprises that operate several product lines, business divisions, stores, and locations spread out geographically may utilize profit margins to evaluate the performance of every unit and compare it to the other.
Profit margins are often in the equation when a business seeks financing. Companies, such as an independent retail store, may require it to request (or restructuring) the loan from banks or other lenders. It is also important when applying for loans against businesses as collateral. Companies that issue loans to raise capital must disclose the purpose they intend to use the capital they have collected. This will provide investors with information about profits margins that could be achieved through cutting costs, or through growing sales or the mix of both. The figure has become an integral component of the equity valuations that are part of the primary market for first public offering (IPO).
In the end, profit margins are a significant aspect for investors. Investors considering investing in the development of a specific startup may want to know the profit margin of the service or product being developed. Investors tend to focus on their respective profits when comparing ventures or stocks to find the most profitable ones.
Comparing Profit Margins
However, profit margins cannot be the sole factor in evaluation since every business has its own specific business. In general, businesses with lower profit margins, such as transportation and retail, will have high turnover and revenues that contribute to high profits, despite the comparatively small profit margin. High-end luxury items have low sales, yet their high yield per unit makes the up for the enormous profits. Below is a comparison of the profit margins of four of the longest-running and profitable businesses from the retail and technology space: