Profit Margin

Profit margin is an important profitability ratio used by the management, financial analysts, and investors to know how much profit the company makes against the sales made and is calculated by dividing the profits generated during the period by the sales.

Thus, it shows the capacity of the business to make a profit from the revenue it earns. A business with a higher profit margin is considered more profitable than its peers. However, it also depends significantly on the type of industry, market, economic and political conditions, and technological changes.

• Profit margin is a crucial profitability ratio used by management, financial analysts, and investors to assess a company's ability to generate profit from sales.
• It is calculated by dividing the profits generated by the sales during a specific period.
• Profit margin is also referred to as gross margin or gross profit ratio.
• It represents the additional sales proceeds generated in the observed period after considering the cost of goods sold but before accounting for administrative, selling and distribution, and financing expenses.

The profit margin ratio is the method of measuring the profit earning capacity of a company in relation to the revenue that it earns over a period of time. It is calculated by dividing the profit made by the revenue earned and is expressed as a percentage.

The margin shows the percentage of profit generated for each dollar earned from selling the products and services. It helps investors, analysts, and other stakeholders assess the company’s financial position, which facilitates them in making informed investment decisions. A high margin signifies a strong financial condition, whereas a low margin is a negative signal for stakeholders.

It also denotes the control and management methods of the day-to-day working of the company. If the management is strong and skilled enough to understand the market trends and the various operating rules and procedures are in place and implemented correctly, the business can grow quickly and become profitable. Thus, the profit margin ratio increases.

Let us discuss the formula to calculate profit margin in different ways:-

#1 - Gross Profit Margin

It is also known as gross margin or gross profit ratio. It is calculated as per below: –

Gross Profit Margin Formula = (Sales – the Cost of Goods Sold)/Sales or Gross Profit/Sales

#2 - Operating Profit Margin

The operating margin is calculated as follows:

Operating Profit Ratio Formula = Operating profit/Sales or EBIT/Sales

Or (Net profit as per profit and loss account + non-operating expenses – non-operating incomes) * / Sales.

#3 – Net Profit Margin

It is also known as net margin or ratio on net profit. The net margin is computed below: –

Net Margin Formula = Profit After Tax (PAT)/Sales or Net profit/Sales

The above a the different  types of profit margins calculated in any business and their formula used.

Let us look at the calculation steps in details.

#1 - Gross Profit Margin

• The ratio measures the gross profit ratio on the total sales made by the company.
• The gross profit represents the excess of sales proceeds during the period under observation over their cost before taking into account administration, selling and distribution, and financing charges. The ratio measures the efficiency of the company's operations, and one can also compare this with the previous years' results to ascertain the efficiency.
• When everything is normal, the gross profit margin percent should remain unchanged, irrespective of the level of production and sales. That is so because it stands on the hypothesis that while computing gross profit ratio, all expenditures are to be subtracted, which are directly volatile with sales.

As an example of the gross profit ratio, let us look at the chart below. This chart compares the gross margins of Amazon, Etsy, Alibaba, and eBay.

source: ycharts

• We note that eBay has the highest gross margin levels (~79.39%), followed by Alibaba and Etsy.
• Amazon's gross profit ratios were stagnant until 2012 (~20%). However, its gross margins have steadily increased in the past three years (~33.04% in FY 2016).

One might compare the margin of gross profit with that of competitors in the industry to assess the operational accomplishment of other industry players.

#2 - Operating Profit Margin

It is also known as operating margin or operating profit ratio, or EBIT margin (Earnings before interest and taxes).

• This ratio to calculate profit margin for operating profit, estimates the effectiveness of the operations of the company.
• The ratio concentrates on the profit margin of business activities before tax deduction and interest.
• This ratio reflects the operating margin on profit on the total sales after deducting all expenses, excluding tax and interest.

As an example of the EBIT margin, let us look at the chart below. This chart compares the operating margins/EBIT margins of Amazon, Etsy, Alibaba, and eBay.

source: ycharts

• Alibaba and eBay show a healthy operating margin level (greater than 25%). However, Amazon just managed to be positive at the EBIT level.
• Additionally, even though Etsy had a healthy gross margin (approximately 64%), its operating margin is negative (~0.69%).
• Etsy's marketing, product development, and general and administrative costs are unusually higher. That results in a negative EBIT margin.

source: Etsy SEC Filings

Please note that operating income can be considered the "bottom line" from operations.

#3 - Net Profit Margin

• This profit margin equation for net profit reflects the net margin on profit on the total sales after deducting all expenses covering interest and taxation.
• One important point that we should note here is that net margin can increase or decrease due to non-recurring items.
• Therefore, it is important to consider those before we conclude.

As an example of net margin, let us look at the chart below. This chart compares the net margins of Amazon, Etsy, Alibaba, and eBay.

source: ycharts

• Alibaba and Ebay's profitability is very high (greater than 20%).
• Amazon just managed to show barely positive net margin levels.
• On the other hand, Etsy has a negative profit margin (~19.8%).

Example 1

ABC Ltd. has made plans for the next year. It is estimated that the company will employ total assets of $80,000, 50% of which will be financed by borrowed capital at an interest rate of 16% per year. The direct costs for the year are estimated at $48,000, and all other operating expenses are estimated at $8,000. They will sell the goods to customers at 150% of the direct costs. The income tax rate is assumed to be 50%.

We are required to calculate the following: -

(a) Gross margin,

(b) Net margin

(c) EBIT Margin.

The solution to Profit Margin - Example 1

Calculation of sales

Sales = 150 % of cost = $ 48,000 * 150 / 100 = $ 72,000

Calculation of Profits

Calculation of Gross Margin

Gross Margin = Gross Profit * 100 / Sales = 24,000 * 100 / 72,000 = 100 / 3 = 33.33 %

Calculation of Net Margin

Net margin = Profit after-tax or net profit * 100 / Sales = 4,800 * 100 / 72,000 = 20 / 3 = 6.7 %

Calculation of EBIT Margin

EBIT Margin = Operating profit or EBIT * 100 / Sales = 16,000 * 100 / 72,000 = 100 / 6 = 16.67 %

Example 2

Z Ltd. has the following information:-

We are required to interpret and analyze the changes in profitability margin.

Solution to Profit Margin - Example 2

Technology Sector Example

Below are the top 20 companies in the technology sector with a Market Capitalization of more than $25 billion.

source: ycharts

• The average gross margin for this peer group is around 46.8%, the average operating margin is 17.8%, and the net margin is 15.3%.
• Facebook and Adobe have the highest value in the profit margin equation in this peer group since they do not sell tangible products (no raw material as they are into software/internet where direct costs are less).
• Though Apple has a gross margin, which is way low than Facebook, they have a higher direct cost (including the manufacturing, raw material, and direct labor costs). However, Apple does well at the operating level (~27.8%) and profit margin levels (21.2%).
• Salesforce.com is the only company in the peer group with a negative profit margin (~0.7%). It is even though it has an exceptionally high gross margin.
• Salesforce.com's marketing and sales costs are around 50% of the total revenue. With this unusually high marketing expense, the company's profitability margin suffers and is negative.

source: Salesforce SEC Filings

Utilities Sector Example

Below are the top 12 companies with more than $25 billion in the utility sector market capitalization.

source: ycharts

• The average gross margin for this utility peer group is around 51.9%, the average EBIT margin is 19.0%, and the net margin is 10.6%.
• We note that the highest gross margins for the utility sector are less than that of the technology sector. It is expected primarily due to higher direct costs (manufacturing, raw material, transmission, etc.) associated with the utility sector.
• Engiy (ticker – ENGIY) is the only company that has a negative EBIT margin (~4.6%) and a negative net margin (~6.6%).
• American Electric, Dominion Resources, and Duke Energy have a robust Gross Profit Margin (>60%), EBIT margins (>20%), and net margins (>12%).

The profit margin percent is a very useful financial metric for any business due to the following reasons.

• Decision making – It helps management and stakeholders take decision regarding investment or planning for future expansion.
• A sign of efficiency – A high margin indicates efficiency of the management because the company is able to generate good profit on investment and sales. It is a good measure of success.
• It attracts investors – If the margin of profit is good, then investors become confident that the company is performing well. If they put their money in the business, they can expect a good return. This increases the confidence level.
• Competitive – The company with good margin of profit is a level above the peers in the competitive market. They have more opportunities because people prefer buying their goods leading to a continuous demand throughout the year.
• Growth potential – A very high profit margin percent means the entity has more funds to invest and expand. As a result, it has better growth potential and the necessary resource to adapt to new technology and buy better equipment.

Thus it provides an insight into how the entity is performing, the efficiency level and future growth potential.

Now let us look at the various limitations of the concept.

• It varies with industry – The comparison of companies can be made only if the industry or the sector is same. The margin or profit cannot be compared for entities across different sectors because it depends on the type of business. Usually technology companies have higher profits than retailers or producers.
• Limited scope – It can only measure the profitability using sales figures. But the profits also depend on debts, capital expenditures, taxes, etc.
• Not suitable for short term – For short term, the company may be profitable but for long term, factors like political and economic conditions affect the market, leading to a change in profitability. Thus, the margin should be used for long term so that it is possible to get the real picture.
• Manipulation- It is possible for companies to manipulate the figures to show goods margins of profit leading to a miscommunication among investors and other stakeholders.
• Does not consider cash flow – The method does not account for the cash flow. The company may have good margin but due to low cash figures, the day to day operations may suffer.

Thus, even though it is an important metric, bth the pros and cons of the method should be considered.  

This has been a guide to what is Profit Margin. We explain the formula and how to calculate it along with examples, importance and limitations.

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