What is Profit Margin?
Notes from the video ‘Diffusion Academy| Finance |What is Profit Margin?‘ :
What is Profit Margin?
Profit margin is a profitability ratio that measures the amount of net income earned with every dollar of sales generated.
The profit margin can be calculated by dividing the net income by net sales.
Net income of a company can be calculated by subtracting the total expenses of a company, which includes the operating cost and tax expenses, from the company’s total revenue.
Net sales can be calculated by subtracting any returns or refunds from the gross sales.
Profit margins are usually expressed as a percentage and measures how much a company keeps in earnings for every dollar of sales made.
Let’s illustrate this with an example:
Suppose Company C’s revenue is $100,000 and its total expenditure is $50,000 for one year.
When we substitute these values into the profit margin formula, we get a net income of $50,000 divided by net sales of $100,000.
So, Company C yields a profit margin of 50%, or in other words, for every dollar of sales Company C makes, it earns 50 cents.
Profit margin is useful in several ways:
Profit margin are used by internal management to set performance goals for the future.
Usually a reduction in profit margin would suggest a myriad of problems for the companies for example, poor expense management or lacklustre sales.
Investors would want to know whether the company is making enough money to distribute dividends. One of the indicators they will look at is the company’s profit margin.
While profit margin is helpful and popular for estimating a company’s profitability, it does have limitations.
Although profit margin is useful for comparing companies in the same industries, it may not be very meaningful to compare between companies in different industries with different business models.
I will illustrate this with an example:
Let’s take a look at Shops X and Y:
Shop X is a discount store that sells products at prices lower than other retail outlets.
Shop X has a high overhead because it needs to have more shop space and more employees to sell more products.
Due to its high expenditure, Shop X has a low profit margin.
Across the street, we have Shop Y – a shop that sells luxury handbags.
It has relatively low overhead because it has a small shop space and only two employees to sell its luxury handbags.
Because of its modest expenditure, Shop Y has a relatively high profit margin.
Even though Shop X has a lower profit margin than Shop Y, Shop X has a much higher revenue compared to Shop Y because much more sales are made in Shop X than in Shop Y.
As such, we can see that it is meaningless to compare profit margin between companies in different industries because they have different business models and revenue streams.