When you hear about the profit margins in various businesses, what this refers to is a ratio of profitability. This ratio is calculated by taking net income divided by revenues, or net profits divided by sales. This calculation measures what part of each sales dollar a company actually keeps as earnings.
Usefulness of Knowing Profit Margins in Various Businesses
Knowing the profit margins of various businesses is useful when you want to compare companies engaged in similar industries. It is used as a measuring tool. Higher profit margins point toward a more profitable company, and one that better governs their business practices to ensure better control over costs when compared to their industry competitors.
Understanding Profit Margins
For the small business owner, understanding profit margins does not have to be complicated. For the sake of breaking it down into simple terms, say the company's profit margin is 20 percent. This means that 20 cents of every sales dollar is net income for the company. This is different than earnings, which is why understanding the profit margin can help to measure the health of your company. Business can be the same or sales can even be up which means earnings go up, however, if the business owner's costs go up, just because earnings have increased doesn't mean the profit margin has gone up. Profit margin is a true indicator of your company's financial health, because let's face it; your company is in business to make money.
The three key profit-margin ratios include:
Gross Profit Margin
The gross profit margin shows the profit a company makes on cost of sales and indicates how efficiently management uses employees and supplies in the production process. The calculation to determine this ratio is:
- Gross Profit Margin = (Sales - Cost of Goods Sold)/Sales
Operating Profit Margin
For the operating profit margin, you compare earnings before interest and taxes (EBIT) to sales. The operating profit margins determine how successful a company's management is in generating income from the operation of the business. High operating profits can indicate that the company has efficient control of costs, or that sales are rising quicker than the cost of operation. Some people think this ratio is a more reliable measure of business profitability because it is more difficult to manipulate than net earnings.
- Operating Profit Margin = EBIT/Sales
Net Profit Margin
Net profit margins is generated from all aspects of a business and compares net income with sales. Just like gross and operating profit margins, net margins vary between industries. If you compare a company's gross and net margins, you can get a good idea of non-production and non-direct costs including things like:
- Marketing costs
- Net Profit Margins = Net Profits after Taxes/Sales
Profit Margins as Investing Tool
On a bigger scale, the importance of profit margins in various businesses comes into play for investors, too, because profitability is reflected in the price of a share, and the bottom line is often what investors look at first. But while it is easy to rely on net earnings alone to gauge profitability, a smart investor knows how to evaluate the different aspects of profitability to take in the big picture. This includes:
- How efficiently resources are used
- How much income the company generates from operations
Investors who take time to calculate a company's profit margin can see how well a company generates and retains money. Using the profit margin ratios offers a deeper look into profitability, beyond assets, equity or invested capital. In fact, determining the operating profit gives investors a chance to run profit-margin comparisons between businesses that don't disclose separate figures on cost of goods sold.
Sample Comparison of Various Businesses and Profit Margins
To bring this topic some clarity, let's consider the international airline industry including companies like British Airways, United and Quantas. They have a gross margin of 5 percent. However, its net margin is a bit lower, at around 4 percent. Now compare that to, discount airline companies like Southwest Airlines which generate an average gross margin of about 29 percent, with a net margin is around 11 percent. Studying these differences sheds light on this industries' distinct cost structures. Comparatively, the discount airline industry spends proportionately more on items like finance, administration and marketing, and less on things like flight crew salaries and fuel.
If a company profit margin is high, it usually indicates that it has an advantage or two over its competition.
Learning to analyze profit margins opens the door to understanding the profitability of various companies. You can learn how effective management is at squeezing profits from sales, and better measure the company's financial health to understand whether or not it would be able to withstand a downturn. However, it's important to remember that this is not a perfect science. Financial data can change quickly so your ratios are only as good as the accuracy of the data used to calculate them.