Profitability Ratios

Profit margin measures the amount of profit a company earns from its sales and is calculated by dividing profit (gross or net) by sales.

Profit margin is one of the most used profitability ratios. Profit margin refers to the amount of profit that a company earns through sales.

The profit margin ratio is broadly the ratio of profit to total sales times 100%. The higher the profit margin, the more profit a company earns on each sale.

Since there are two types of profit (gross and net), there are two types of profit margin calculations. Recall that gross profit is simply the revenue minus the cost of goods sold (COGS). Net profit is the gross profit minus all other expenses. The gross profit margin calculation uses gross profit and the net profit margin calculation uses net profit. The difference between the two is that the gross profit margin shows the relationship between revenue and COGS, while the net profit margin shows the percentage of the money spent by customers that is turned into profit.

\(\dfrac{\text{Net Profit}}{\text{Sales}} * 100\)

Net Profit Margin The percentage of net profit (gross profit minus all other expenses) earned on a company's sales.

\(\dfrac{\text{Gross Profit}}{\text{Sales}} * 100\)

Gross Profit Margin The percentage of gross profit earned on the company's sales.

Companies need a positive profit margin to earn income, although a negative profit margin may be advantageous in some instances (e.g., intentionally selling a new product below cost to gain market share).

The profit margin is mostly used for internal comparison. It is difficult to accurately compare the net profit ratio for different entities. Individual businesses' operating and financing arrangements vary so much that different entities are bound to have different levels of expenditure. Comparing one business' arrangements with another has little meaning. A low-profit margin indicates a low margin of safety. There is a higher risk that a decline in sales will erase profits and result in a net loss or a negative margin.