Profit Margin Ratio

Every company and business organization needs to carry out a detailed financial examination of its figures from time to time, in order to ascertain the financial health and the profitability of the business. The ultimate goal of every company is to earn more profits, and the profit margin ratio is one such accounting figure that helps in this study.

As the name suggests, it simply implies the amount of profit the company is making on a pro-rata basis. When one simply looks at the sales figures of a company, it is easy to get carried away, so it is necessary to remind oneself about the actual profit that is being made in such a situation. By learning to carry out profit margin ratio analysis, one can compare the company's state of affairs with other companies in the same market, and one can also judge the growth of the same company over a period of time.

Profit Margin Ratio Formula

The simple formula is as follows.

Profit Margin = Net Income Total Sales or Total Revenue

This figure is usually expressed in the form of a percentage, as this makes the process of comparison much easier. With the application of this formula the company can then proceed to determine how much profit it is making for every dollar of sales that they have experienced. A low ratio indicates high costs of production, and this compels the company to undertake measures in order to reduce these costs, so that they can increase their profit margin.

Suppose that a company ABC Inc. has total sales figures of $100,000 for a period of time. In this same period their net income (after taxes and other deductions) is $10,000. This means that their ratio is 10,000 100,000, or 10%. This further implies that for every dollar that they get the profit that they make is $0.10. Needless to say, this indicates the profitability of the company, and this can be compared to other companies in the same market.

Now say another company XYZ Inc. functions in the same market and has total sales of $300,000. At first glance one would think that this company is more profitable. But their net income is only $15,000 for the same period. Thus their profit margin ratio is only 5% (15,000 300,000). Thus, even though their sales figures are higher, they only make a profit of $0.05% for every dollar that they get. XYZ Inc. thus needs to focus more on reducing their costs of production.

The same figures for ABC Inc. over two different financial years can also be compared to see how well they have grown in that time period. Even if the company has increased sales figures for a period of say, two years, the rise in the profit margin ratio is what they should really be looking at. This will give an accurate indication of improvement in their operations and profitability.

Different Types of Profit Margins

You may have also heard of the terms net and gross profit ratios, without knowing the exact differences between gross and net profit. Net profit simply implies the gross profit value after all expenses have been subtracted. By comparing these two ratios and the difference between them, the company can also determine the effect that the various expenses are having on the profitability. The expenses that we speak of here are taxes, interest, overhead expenses and other such expenses.

Comparing these two ratios with each other also gives the company some indicators about its efficiency. A rising gross profit margin indicates that trading activities are doing well, but a rising net profit margin indicates that the company is managing its expenses well and is managing its day-to-day operations efficiently.

There are many different profit margin ratio calculators that you can locate on the Internet, and these will help you calculate this ratio accurately. Small businesses can make use of such calculators, but medium-sized and large businesses will have an auditing department or an external auditor to handle these projections and calculations.