What Are Margins in Finance?
Margins are important in the financial arena and in business. In general, the term margin means the difference between a product's (or service's) selling price and the cost of production stated in percentage terms. Put another way, margins are the incremental mark-up on the price of a product above the cost, or marginal mark-up.
Other People Are Reading
-
Misconceptions
-
The terminology between "margin" and "margins" needs to be addressed. If you would ask a finance professional about margin, he would immediately assume that you're referring to buying on margin or buying stock on margin. Most brokerages allow investors to borrow money with the existing assets (usually stocks or bonds) in the account as collateral. Then the account holder uses this borrowed money to buy stocks or bonds. The buying of these stocks or bonds with the borrowed money is known as buying on margin.
The word "margins" means something entirely different. Margins refer to a type of financial ratio. When an analyst wants to find the "Profit Margin," the calculation would look like this: Profits divided by Revenue times 100 percent. Most margin calculations represent a percentage of revenue. The calculation of Gross Margins look like this: Gross Profit divided by Revenue times 100 percent.
According to Wikipedia.com, "Operating Profit Margin is a measurement of what proportion of a company's revenue is left over, before taxes and other indirect costs (such as rent, bonus, interest, etc.), after paying for variable costs of production as wages, raw materials, etc. A good operating margin is needed for a company to be able to pay for its fixed costs, such as interest on debt."
Types
-
Gross Margins: Gross Profit (Revenue minus Cost of Good Sold equals Gross Profit) divided by Revenue times 100 percent
Operating Margins: Operating Profit (Gross Profit minus Operating Expenses equals Operating Profit) divided by Revenue times 100 percent
EBITDA Margins: EBITDA (Earnings Before Interest Taxes Depreciation and Amortization--for many services businesses, this is Operating Profit) divided by Revenue times 100 percent
EBIT Margins: EBIT (Earnings Before Interest and Taxes--for manufacturing or asset intensive businesses, this is Operating Profit) divided by Revenue times 100 percent
Net Margins: Net Income divided by Revenue times 100 percent.
Product Margins: The difference between a product's (or service's) selling price and the cost of production stated in percentage terms.
-
Significance
-
An analyst can eyeball the margin's ratios and determine much about the business. If the business has low Gross Margins (25% or lower), the business has a high Cost of Goods Sold and normally this indicates an inventory-based business (a discount retailer) or a people-intensive business (a consulting business). Also, an analyst can look at the Gross Margins of an inventory type of business and see what type of average markup the business charges for its products.
When analyzing two similar companies, an investor can see how efficiently the business manages itself by looking at the Operating Margins. If the two business are in the same industry, the Gross Margins should be very similar. The Operating Margins will tell how effective and efficient the business manages the operations. Many times changing the operations takes much effort and cost, so building the operations correctly the first time will pay dividends in the future by increasing Operating Margins.
Considerations
-
In a general business context, each product or service has its own margin. Some products and services have higher margins than the others. Many times the business promotes the high-margin products as they produce more profits. For this reason, the management and marketing teams should understand the margins of the products and services they sell.
Warning
-
Some businesses pay their salespeople on commission. These commission schedules typically end on the final day of the quarter. Therefore salespeople will many times push or pull a deal at month's end in order to step around the commission schedule to maximize their commission. Due to this "pushing" and "pulling" the margins of one quarter may not represent a "normal" margin percentage. If the business has a few large deals and a salesperson pushes the deal into the next quarter, but still accumulates most of the expense for the deal in the current quarter, this will alter the normal margins. The current quarter will show depressed margins and the following quarter will show margins that are higher than normal. Due to these type of issues, an analyst must understand what the normal margins are by taking an average of the margins over a duration.
-
