Understanding profit margin and its different types

Profit margin is an excellent gauge for how well a company is performing, both compared to its own past performance and its peers’ performance. Essentially, this metric is a measure of profitability.

Investors and businesses, as well as lenders, often use look to profit margin to help them asses how well the company is being managed and whether it has good potential for solid growth.

Usually expressed as a percentage, profit margin is a comparison of a company’s profit to its total sales. Profit margin clarifies how much a company is making for every dollar it is earning in sales. For example, a company with a 15% profit margin would be making $0.15 for ever $1 it earns in revenue. With this metric, you can see profitability at-a-glance and compare it against competitors.

Business owners can calculate their profit margin at any time. Larger public companies are required to report profit margin quarterly and annually along with their public financial filings. Some lenders also ask that a company calculate and report their profit margins regularly, sometimes on a monthly basis, so that they can monitor their credit worthiness. 

Why profit margin is important

A widely used metric, profit margin is that is important for a number of reasons. Primarily, it allows investors to get a solid sense of how the company is making money.

When a company has a better profit margin that its peers, that means it is probably in a better position to outperform in the long-term. Healthy profit margins can reflect good decision making from the executives running the company, which also bodes well for its future growth. In contrast, smaller profit margins may be a red flag that the business is struggling.

Companies regularly check their own profit margin to get a sense of how well they are performing. This helps executives make better decisions about the business development strategy – whether the company should continue on its growth course or change its plan to improve its performance. The profit margin can highlight areas of weakness that need to be addressed so the company can earn more money on what it sells, especially if it’s zero or negative. For example, a company may want to increase the cost of its product to increase its net sales, or it may want to look at ways of reducing expenses.

Finally, lenders look at profit margins to determine how and whether they will provide credit facilities. If the company has strong profit margins, it is more likely to secure competitive financing, or larger loans with lower interest rates.

Of course, many other financial figures like sales growth, expenses and earnings are important, too. But it’s helpful to know how much money a company is making on those sales.

Is there ever a time when profit margin isn’t that useful?

This is an interesting question that can be relevant when analyzing companies that are foregoing short-term profits in the name of long-term growth. Amazon (AMZN) is a good example of this situation. For years, the company invested heavily in growth foregoing profits. Does this mean that the company wasn’t doing well during these years of low profitability? Of course not. Amazon was executing extremely well on its way to being the juggernaut that we know today.

As you can see in this chart from macrotrends, the Amazon profit margins have been all over the place over the last decade:



This example is instructive in that it reminds us that profit margin must be analyzed in the context of the company’s overarching goals. Management of some companies might use the excuse of investing in long-term growth as a reason for low profits, but this company might not be the next Amazon. Analyzing the total picture is the key here. Is the company actually growing top line revenue as a result of these investments? Is the total addressable market massive? If yes, then low profits for a while might be acceptable.

Types of profit margin

The most cited profit margin is net profit margin, which is the bottom-line number after all expenses have been factored in, including one-time expenses and taxes.

There other types of profit margin that each depend on how you calculate the profit. Here are the four main types:

Gross Profit Margin

Gross profit is the most basic profit. With it, you subtract the main expense of the costs of producing a product or providing a service. Other costs, like for advertising, rent or research, as well as any one-time expense and taxes, are included in gross profit. 

Operating Profit Margin

Operating profit is the profit you get after you subtract operating costs like the costs of its headquarters or monthly rent, or costs associated with research and development or marketing. With this calculation, you also subtract overhead, administrative expenses and sales expenses – anything that is connected with running the daily business. Bankers and analysts often using the operating margin to determine whether a company may be in a good position for a buyout. Operating profit is sometimes referred to as EBIT or earnings before interest and taxes.

Pre-Tax Profit Margin

Pre-tax profit is one step further than operating profit in terms of subtracting costs. Here you subtract any one-time or unusual expenses connected to the business. The costs of taxes are still included with pre-tax profit.

Net Profit Margin

Finally, you have net profit margin. Again, this is the most used profit margin figure. It’s the most comprehensive profit, with all expenses excluded so you can see more precisely how much money the business is taking in and how much money it is earning off that revenue. In this step, the cost of taxes is excluded, although dividend payments are not taken out.

Formula for calculating profit margin

Calculating profit margin is straightforward. First, you should be familiar with these basic financial terms:

Total Sales: Total sales, or total revenue, is the amount of money a company has earned during a given time period from selling its products or services.

Net Sales: Net sales are total sales, minus deductions like sales allowances, sales discounts and sales returns. They are close to total sales, but they also take into account refunds, early payment discounts and reductions in price for product defects, among other deductions.

Profit: Profit is the net sales after subtracting all expenses. It is what the company has earned for itself.

COGS: Cost of Goods Sold. These are the costs tied directly to the production and selling of a product or service. It includes expenses like any materials, parts, labor or manufacturing overhead, as well as any shipping expenses.

Then, you calculate each type of profit margin in the following way:

Gross Profit Margin Calculation:

Net Sales – COGS / Net Sales * 100 = Gross Profit Margin

Operating Profit Margin Calculation:

Net Sales – COGS – Operating Expenses / Net Sales * 100 = Operating Profit Margin

Net Profit Margin Calculation:

Net Sales – COGS – Operating Expenses – Taxes, Interest, Other Expenses / Net Sales * 100 = Net Profit Margin

In each type of profit margin calculation, the profit margin increases as expenses decrease and net sales increase.

Example of profit margin calculations

So, with these formulas we can calculate the main types of profit margin. Below, you can follow an example to better understand the formulas.

With this example, we’ll assume the Example Company has the following financial information for the quarter:

• Net Sales of $6.3 million
• COGS of $4.2 million
• Operating Costs of $1.5 million
• Interest, Taxes and Other Expenses of $200,000

Gross Profit Margin Calculation for Example Company:

$6.3 million – $4.2 million / $6.3 million * 100 = Gross Profit Margin of 33%

Operating Profit Margin Calculation for Example Company:

$6.3 million – $4.2 million – $1.5 million / $6.3 million * 100 = Operating Profit Margin of 9.5%

Net Profit Margin for Example Company:

 $6.3 million – $4.2 million – $1.5 million – $200,000 / $6.3 million * 100 = Net Profit Margin of 6.3%

Profit margin shows how much a company makes on each dollar. So, in this case, it would earn $0.33 per dollar according to its gross profit margin; $0.095 on each dollar according to its operating profit margin, and $0.063 on each dollar according to its net profit margin.

You can see that the net profit margin is significantly different than the gross profit margin. As more expenses are factored in, a company’s profit decreases, therefore its profit margin decreases.

What is a good profit margin?

An ideal profit margin varies from industry to industry. So, it’s important not to leap to conclusions when you’re comparing a company’s profit margin with others.

Generally, an average net profit margin is 10%, a 5% profit margin is considered low and a 20% profit margin is considered high. But again, whether or not a profit margin is good for a particular company depends on a variety of factors as the definition of a “good” profit margin varies widely.

For example, in the restaurant industry, profit margins tend to be very narrow because there are a lot of costs involved, including the cost of food, staff, location and cleaning to name a few. In this industry, volume is key to making money because of the narrow profit margins. With restaurants, people are willing to pay more for their food, but not significantly much more than they would pay at the grocery store. Other industries that tend to have lower profit margins are automobile makers, transportation companies and agricultural business.

In contrast, profit margins for beauty products are fairly high. The cost to make the product is not nearly as much as the final sales price that the consumer pays. In this industry, products are marked up so that profit margins are much higher. Luxury goods makers, software companies, gaming companies, and patent-related businesses like pharmaceuticals also tend to have higher profit margins.

So, you can see where it does not make sense to compare the profit margins of companies from two different industries. You may have a highly successful restaurant with slim profit margins compared to a poorly run beauty products company with larger profit margins. In the same way, it doesn’t make sense to compare, say, a technology company’s product margins with a health care company’s profit margins.

Understanding whether a profit margin is “good” depends on many other factors. Generally, newer companies tend to have higher profit margins than established companies because they have fewer expenses and overhead. More established companies have more expenses, such as staff, product additions and facilities, to name a few examples.

One way to measure whether is profit margin is “good” is to measure it over time. So, you can compare a companies profit margin one year to its profit margin the next year to see whether it’s profitability is improving.

Other profitability ratios

Profit margin is only one of a number of ways to measure profitability. Other profitability ratios include return on assets (ROA) or return on equity (ROE).

Return on assets shows investors, business owners or creditors how well a company’s assets are generating money, or how well company managers are managing their resources. ROA is expressed as a percentage, like a profit margin. To calculate it, divide a company’s net income by its average total assets and multiply by 100.

ROA Example Calculation:

So, if a company had $65,000 in net income and $315,000 in total assets, it would have a ROA of 20.1% ($65,000 / $315,000 * 100).

Return on equity is a similar ratio, but it shows how well a company is earning profits based on shareholder equity.

To get it, you divide the company’s net income by its shareholders’ equity and multiply by 100. Shareholder equity is a company’s total assets, but with liabilities such as debt subtracted out.

ROE Example Calculation:

So, if a company had $65,000 in net income and $315,000 in total assets, as well as $45,000 in debt, it would have a ROE of 24.1% ($65,000 / $315,000 – $45,000 * 100).

You can see that when a company is leveraged, or carries debt, its ROE is greater than its ROA.

As with profit margins, its important to compare a company’s ROA or ROE to other companies in the same industry because each industry has a different standard for what is considered a healthy return. If a company has no debt, its ROA and ROE should be equal.

Conclusion

Profit margin shows how a company’s business makes money, and it is one of the most commonly used metrics to gauge the financial health of a company. For investors, creditors, and businesses, turning to a company’s profit margin is a useful way to get a sense of its financial performance, as well as how well its decisions makers are managing the balance sheet.

Profit margins are easy to calculate by dividing income by sales. But remember, when comparing a company’s profit margin figures that this number is industry-specific, so you can’t compare them across the board.

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