In finance, analysts often refer to a company's "margin." A margin is a financial ratio that expresses business profitability in a percentage format. The higher the percentage, the more profitable the business is.
The most common margins used in finance and accounting are net profit margin, gross profit margin and operating margin. Although all three margins involve comparing income to revenue, each focuses on a different type of income.
Net Profit Margin
The net profit margin ratio focuses on a company's net income. Net income equals total revenues from all sources less total expenses. Net income represents how much in earnings is left over to distribute to shareholders as dividends or to reinvest into the business. Because net profit encompasses all company activities, the margin indicates business profitability as a whole.
To calculate net profit margin, follow these steps:
- Subtract total expenses from total revenue to calculate net income. For example, a business with revenues of $500,000 and expenses of $300,000 has a net income of $200,000.
- Divide net income by revenue to find the net profit margin. In this example, the net profit margin is $200,000 over $500,000, or 40 percent.
Net profit margin considers company revenues from all sources. Along with revenues from regular operations, it also considers nonoperating revenues, such as gains from the sale of investments and fixed assets. These revenues tend to be one-off in nature and can't always be duplicated in future years. The operating margin ratio allows the business to home in on operating profits exclusively.
To calculate operating margin, follow these steps:
- Subtract operating expenses from operating revenue to calculate operating income. For example, a business with operating revenues of $400,000 and operating expenses of $200,000 has operating income of $200,000.
- Divide operating income by operating revenue to find the operating margin. In this example, the operating margin is $200,000 over $400,000, or 50 percent.
Gross Profit Margin
Gross profit margin zeros in on gross profit, which is sales revenue less the cost of goods sold. Gross profit represents the amount of profit the business has left over to pay general and administrative expenses. Because gross profit only considers product costs, it helps a business evaluate how efficiently it manufactures goods.
To calculate gross profit margin, follow these steps:
- Subtract cost of goods sold from sales revenue to calculate gross profit. For example, a business with sales revenues of $400,000 and cost of goods sold of $100,000 has a gross profit of $300,000.
- Divide gross profit by sales revenue to find the gross profit margin. In this example, gross profit margin is $300,000 over $400,000, or 75 percent.
Because gross profit margin doesn't consider general, selling and administrative costs, the gross profit margin will always be higher than operating margin.