Profit margin equals net income divided by total revenue -- another formula to determine profit margin is net profit divided by total sales. This profitability ratio helps investors evaluate how adeptly a company's leaders are growing sales and market share, indicating whether internal or external factors remain a stumbling block on the organization's path toward competitive prominence.
Calculating Profit Margin
To calculate profit margin, it's important to correctly compute net income and understand the accounting minutiae that lead to this number. Subtract the cost of sale -- also known as material expense -- from corporate sales to get gross profit. Then, add up all operating expenses, which include things like salaries, interest, office supplies, rent and machinery maintenance. Subtract total operating expenses from gross profit to calculate operating income -- or income from continuing operations, as accountants often call it. Next, deduct non-operating losses and gains -- those that don't happen often -- from operating income to get pretax income, which becomes net income after subtracting taxes.
As a profitability indicator, profit margin sets economically shaky companies apart from organizations that consistently make money. Investors review profit and loss statements, which detail net income and revenues, to understand tools, strategies and tactics on which a business relied to make money during a given period, such as a month or fiscal quarter. For example, an income statement -- the other name for a statement of profit and loss -- shows the major products that are driving profitability, as well as the main expense factors that are decreasing it.
Avoiding Dead Cat Bounces
In a financial glossary, a "dead cat bounce" is a temporary recovery from a long decline in stock prices, after which investment markets continue to fall. Applied to a single company, a dead cat bounce might happen if the business doesn't post consistent profits -- or worse, when it's unsuccessfully coping with commercial tedium and is unable to post a profit. To guard against losing businesses and nosediving investments, financiers evaluate a company's profit margin, compare it to rivals' profitability ratios and industry averages and make sound decisions that hopefully will preserve or increase portfolio values over time.
For the profit margin number to be accurate, a company's leadership must set proper procedures for revenue and expense recording. A corporate bookkeeper debits a revenue account to decrease its worth and credits the account to increase its balance. The bookkeeper posts opposite entries for expense accounts.