What is Profit Margin?
Profit margin is a metric used to determine the degree of profitability of a company or business. It is one of the prevalent profitability ratios. The purpose of using profit margin ratios is to calculate how much money a company or business makes from its activities. Usually, the profit margin is a percentage. The higher it is, the more profitable a company is as well.
The profit margin of a company may describe general aspects of its profitability. However, there are various types of profit margins that give specific information. Usually, the term profit margin refers to the net profit margin of a company.
What is the formula for Profit Margin Ratio?
As mentioned, the term profit margin refers to the net profit margin of a company. Therefore, the profit margin ratio formula will consider the net profit margin ratio of a company. The formula is as below.
Profit margin ratio = Net profits (Net sales – Expenses) / Net sales
The net profit of a company represents its net income after deducting all its expenses from its revenues. All the information needed to calculate the profit margin of a company is available in its Income Statement. Apart from the net profit margin of a company, there are also other types of profit margins.
What are the types of Profit Margin?
Apart from the net profit margin discussed above, there are two other types of profit margins. These include the gross profit margin and the operating profit margin.
Gross Profit Margin
The gross profit margin of a company shows the company’s gross profits in relation to its sales. The gross profit margin ratio is a measure used to calculate it. The formula to calculate the gross profit margin ratio of a company is as below.
Gross profit margin ratio = Gross profit (Net sales – Cost of goods sold) / Net sales
The gross profit margin uses a company’s gross profit instead of its net profits as in the net profit margin. A high gross profit margin ratio indicates high profitability from a company’s products or services without considering indirect costs.
Operating profit margin
The operating profit margin of a company is its operating profits in relation to its net sales. Usually, companies report their operating profits on their Income Statements. The operating profit margin ratio is a metric used to calculate it, which is as below.
Operating profit margin ratio = Operating profit (Net sales – Operating expenses) / Net sales
The operating profit margin ratio is similar to the other ratios mentioned above, the higher, the better. The higher it is, the more profits a company makes from its operations.
A company, Red Co., generated net sales of $10 million. Its gross profits were $4 million. Similarly, its operating profits amounted to $2 million. Its net profits were $1 million. Therefore, the profit margins of the company were.
Gross Profit Margin = 40% ($4 million / $10 million)
Operating profit margin = 20% ($2 million / $10 million)
Net profit margin = 10% ($1 million / $10 million)
The profit margin of a company shows its profitability from various aspects. Usually, the term profit margin means the net profit margin. However, there are also other types of profit margins, including the gross and operating profit margins. The higher the profit margins of a company are, the more profitable it is.