What is a Profit Margin
Businesses and individuals across the globe perform for-profit economic activities with an aim to generate profits. However, absolute numbers - like $X million worth of gross sales, $Y thousand business expenses or $Z earnings - fail to provide a clear and realistic picture of a business’ profitability and performance. Several different quantitative measures are used to compute the gains (or losses) a business generates, which make it easier to assess the performance of a business over different time periods, or compare it against competitors.
Profit margin is one of the commonly used profitability ratios to gauge profitability of a business activity. It represents how much percentage of sales has turned into profits. Simply put, the percentage figure indicates how many cents of profit the business has generated for each dollar of sale. For instance, if a business reports that it achieved 35 percent profit margin during the last quarter, it means that it had a net income of $0.35 for each dollar of sales generated.
Understanding Profit Margin
BREAKING DOWN Profit Margin
While proprietary businesses, like local shops, may compute profit margins at their own desired frequency (like weekly or fortnightly), large businesses including listed companies are required to report it in accordance with the standard reporting timeframes (like quarterly or annually). Businesses which may be running on loaned money may be required to compute and report it to the lender (like a bank) on a monthly basis as a part of standard procedures.
Profit margin is calculated by dividing the net profits by net sales, or by dividing the net income by revenue realized over a given time period. In the context of profit margin calculations, net profit and net income are used interchangeably. Similarly, sales and revenue are used interchangeably. Net profit is determined by subtracting all the associated expenses, including costs towards raw material, labor, operations, rentals, interest payments and taxes, from the total revenue generated.
Profit Margin = Net Profits (or Income) / Net Sales (or Revenue)
= (Net Sales - Expenses) / Net Sales
= 1- (Expenses / Net Sales)
Dividends paid out are not considered an expense, and are not considered in the formula.
Taking a simple example, if a business realized net sales worth $100,000 in the previous quarter and spent a total of $80,000 towards various expenses, then
Profit Margin = 1 - ($80,000 / $100,000)
= 1- 0.8