The Significance of Profit-Margin Ratios
Profit is the amount of money a company earns after accounting for costs and expenses. It is useful to determine if a company is controlling costs and expenses efficiently, since managing costs efficiently increases profit. Profit margin is a measure of how well expenses are controlled and managed.
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Formula
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Profit margin is easy to calculate, as it is simply the net income or net profit of a company divided by revenue earned. This is the most common profit margin and is the same as net profit margin, since it uses net income to calculate. Net income or profit calculates as total company revenue or earnings minus any expenses such as operating expenses, taxes and depreciation. Higher profit margins are better, as they indicate the company is efficiently controlling costs and expenses.
Significance
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The significance of profit margin is that it is a good indicator of how well a company is performing and managing business operations. In order to maximize profit, a company must operate efficiently and control costs and expenses. A company can show positive profit but manage expenses poorly, which means that profit could be higher with more efficient expense management.
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Margin Ratio and Types
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Profit margin mathematically is a ratio stated as a percentage. For example, a company with a 10 percent profit margin indicates that the company earns 10 cents for each $1 of company sales. There are different types of profit margins such as gross profit margin that calculate the same way, but with different profit types as the starting point. For example, gross profit margin uses gross profit to calculate the margin which is prior to expenses, and is a good way for a company to price goods for sale.
Example
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Assume a company has gross revenue or sales of $20,000. The company spends $12,000 on taxes, operating expenses and all other expenses for net income of $8,000. The net profit margin is net income divided by sales or revenue, which is $8,000 divided by $20,000 for a net profit margin of 0.4 or 40 percent. This means that the company profit is 40 cents for every $1 of sales, which seems to be a high number but may not be. Normal profit margins vary by industry, so what is high for a company that sells books is probably low for a company that sells oil.
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