Determining whether or not your business is profitable is an exercise you should conduct fairly frequently. It’s not only important for you to understand the financial health of your business, but this information may come in handy when you’re looking for investors or want to take out a loan. Companies with high profit margins are considered a much safer bet amongst lenders and creditors than those with lower profit margins.
What is a Profit-Margin Analysis?
A profit-margin analysis is measured by examining the profit margin ratio, which illustrates what percentage of a company’s sales are left after all expenses are paid. It is most often used by creditors and investors to determine how effectively a company converts its sales to income. In many ways, it is the easiest way to determine if a company is operating efficiently.
How is a Profit-Margin Analysis Conducted?
A profit-margin analysis is actually a very simple ratio that consists of a company’s net income divided by its net sales. Net income is normally the last figure reported on the company’s income statement.
In general, a higher ratio indicates that a company is operating efficiently and profitably. For the most part, this is done by either raising revenue and keeping expenses constant, or by keeping revenue constant and lowering expenses.
While looking at the overall profit margin of an organization is helpful for the big picture, there are three other ratios that can be examined to get a better idea of how the company handles its finances.
1. Gross Profit Margin
True to its name, gross profit margin measures the amount of profit a company makes based on the cost of goods that are sold. Your cost of goods sold includes all expenses related to labor, raw materials and manufacturing of the goods. Once you have that, calculate your gross profit margin with this equation:
Gross Profit Margin = (Sales – Cost of Goods Sold) divided by Sales
2. Operating Profit Margin
Your business’ operating profit margin compares a company’s operating income (also known as earnings before interest and taxes, or EBIT) to its sales. By seeing how much of your profit is left after paying for variable expenses, the operating profit margin measures how successful the organization is at generating income from simply operating the business. It is calculated using the following equation:
Operating Profit Margin = [Sales – Cost of Goods Sold – Selling, General and Administrative (SG&A) Costs] divided by Sales
3. Net Profit Margin
This margin is most commonly referred to as the “bottom line.” It is the profit that is generated from all phases of the business minus taxes. It is calculated using the following equation:
Net Profit Margin = Net Income after Taxes divided by Sales
How to Use Profit-Margin Analysis
If your company finds that its overall profit margin is lacking, it might be worth running each of the above calculations to see if a certain area is proving to be a challenge. It’s possible that your organization excels at managing its raw materials and resources to manufacture goods, but is challenged by rising expenses or other fixed costs.
The best way to determine if your profit margin is “normal” for your type of business is to compare it to other organizations in your industry and of a similar size. Additionally, consistently high profit margins may indicate that an organization can survive an economic downturn or other financial setback and still remain in business. This is further evidence that the company is a low-risk investment for lenders and investors.
It’s best to know your company’s financial health before you go seeking investors or before looking for ways to increase revenue or lower expenses. By having a good handle on these different profit margins you’ll be able to make smart, forward-thinking decisions when it comes to your business’ bottom line.