Profit Margin

Profit Margin Definition

Profit Margin is an important profitability ratio used by the management, financial analysts and investors in order to know that how much profit the company against the sales made and is calculated by dividing the profits generated during the period by the sales.

Let us look at the example of Etsy above. We note that the Gross Margin of the company is around 64.5%; however, its Operating Margin and Profit Margins are negative at -0.69% and -19.8%, respectively. Why is this so?

However, before we answer the question of “Why,” it is important to understand the meaning of three types  – Gross margin, operating margins, and net profit margins!

Profit Margin

Let us discuss each one of them in detail –

#1 – Gross Profit Margin

It is also known as gross margin or gross profit ratio. It is calculated as per below –

Gross profit margin formula = (Sales – the cost of goods sold)/Sales or Gross profit/Sales

As an example of the gross profit ratio, let us look at the chart below. This chart compares the Gross Margins of Amazon, Etsy, Alibaba, and eBay.

Gross-Margin-Analysis

source: ycharts

  • We note that eBay has the highest Gross Margin Levels (~79.39%), followed by Alibaba and Etsy.
  • Amazon’s gross profit ratios were stagnant until 2012 (~20%); however, its gross Margins have moved up steadily in the past three years (~33.04% in FY2016).

The margin of gross profit might be compared with that of competitors in the industry to assess the operational accomplishment respective to other players in the industry.

#2 – Operating Profit Margin 

It is also known as operating margin or operating profit ratio or EBIT Margin (Earnings before interest and taxes).

The operating margin is calculated as follows:

Operating Profit Ratio Formula = Operating profit/Sales or EBIT/Sales

Or (Net profit as per profit and loss account + non-operating expenses – non-operating incomes) * / Sales.

  • This ratio estimates the effectiveness of the operations of the company.
  • The ratio is created to concentrate on the margin on profits due to business activities before the deduction of tax and interest.
  • This ratio reflects the operating margin on profit on the total sales after deducting all expenses, excluding tax and interest.

As an example of the EBIT Margin, let us look at the chart below. This chart compares the Operating Margins / EBIT Margins of Amazon, Etsy, Alibaba, and eBay.

Operating-Margin-Analysis

source: ycharts

  • Alibaba and eBay show a healthy operating margin level (greater than 25%). However, Amazon just managed to be positive at the EBIT level.
  • Additionally, we note that even though Etsy had a healthy Gross margin (approximately 64%), its Operating Margin is negative (~0.69%).
  • Etsy’s Marketing, Product Development, and General & Administrative costs are unusually higher. This results in a negative EBIT Margin.

etsy-operating-profit-margins-are-negativesource: Etsy SEC Filings

Please note that Operating income can be thought of as the “bottom line” from operations

#3 – Net Profit Margin

It is also known as net margin or ratio on net profit. The net margin is computed below:

Net margin formula  = Profit After Tax (PAT)/Sales or Net profit/Sales

As an example of Net Margin, let us look at the chart below. This chart compares the Net Margins of Amazon, Etsy, Alibaba, and eBay.

Net-Margin-Analysis

source: ycharts

  • Alibaba and Ebay’s profitability is very high (greater than 20%).
  • Amazon just managed to show barely positive Net margin levels.
  • Etsy, on the other hand, has a negative profit margin (~19.8%)

Examples

Example 1

ABC Ltd. has made plans for the next year. It is estimated that the company will employ total assets of $ 80,000, 50% of the being financed by borrowed capital at an interest rate of 16 % per year. The direct costs for the year are estimated at $ 48,000, and all other operating expenses are estimated at $ 8,000. The goods will be sold to customers at 150 % of the direct costs. The income tax rate is assumed to be 50 %.

You are required to calculate the (a) Gross margin, (b) Net margin (c) EBIT Margin.

Solution to Profit Margin – Example 1

Calculation of sales

Sales = 150 % of direct costDirect CostDirect costs are costs incurred by an organization while performing its core business activity and can be attributed directly in the production cost, such as raw material costs, wages paid to factory staff, power & fuel expenses in a factory, and so on, but do not include indirect costs such as advertisement costs, administrative costs, etc.read more = $ 48,000 * 150 / 100 = $ 72,000

Calculation of Profits

ParticularsAmount
Sales                       72,000
Less: Direct costs                       48,000
Gross Profit                       24,000
Less: Operating Expenses                        8,000
Earnings before interest and tax (EBIT) or Operating profit                      16,000
Less : Interest on borrowed capital ( 16 % on 50 % on 80,000 )                       6,400
Earnings after tax (EAT)                       9,600
Less : Tax @ 50 %                       4,800
Profit after Tax or Net profit                       4,800

Calculation of Gross margin

Gross margin = Gross profit * 100 / Sales = 24,000 * 100 / 72,000 = 100 / 3 = 33.33 %

Calculation of Net margin

Net margin = Profit after-tax or net profit * 100 / Sales = 4,800 * 100 / 72,000 = 20 / 3 = 6.7 %

Calculation of EBIT Margin

EBIT Margin = Operating profit or EBIT * 100 / Sales = 16,000 * 100 / 72,000 = 100 / 6 = 16.67 %

Example 2

Z Ltd. has the following information

ParticularsYear 1Year 2
Gross margin21 %20 %
Operating margin15 %15 %
Net Margin10 %11 %

You are required to interpret and analyzed the changes in profitability margin

Solution to Profit Margin – Example 2
ParticularsDirectionInterpretation
Gross marginDecreaseThe decrease in Gross profit indicates sufficient funds do not avail of operating expenses and taxes. It states either increases in the Sale price or diminishing of Direct expenses
Operating MarginConstantThe remaining Constant of operating margin indicates in spite of the decline of gross margin; the company has benefitted in terms of operating performance.
Net marginIncreaseEnhancing of net margin indicate that a company is more effective in converting revenue into actual profit

Technology Sector Example

Below are the Top 20 companies in the Technology sector with Market Capitalization of more than $25 billion.

technology-sector-profitability

source: ycharts

  • The average Gross Margin for this peer group is around 46.8%, the Average Operating Margin is at 17.8%, and the Net Margin is at 15.3%
  • Facebook and Adobe have the highest gross Margin in this peer group.  It is primarily due to the fact that they don’t sell tangible products (no raw material as they are into software/internet where direct costs are less)).
  • Though Apple has a Gross Margin, which is way low in comparison to Facebook, this is because they have a higher direct cost (including the manufacturing, raw material, and direct labor costs). However, Apple does really well at the Operating level (~27.8%) and Profit Margin Levels (21.2%)
  • Salesforce.com is the only company in the peer group that has a negative Profit Margin (~0.7%). It is despite the fact that it has an exceptionally high Gross Margin.
  • Salesforce.com Marketing and sales costs are around 50% of the total revenue. With this unusually higher marketing expense, the company’s profitability margin suffers and is negative.

salesforce-com-analysissource: Salesforce SEC Filings

Utilities Sector Example

Below is the list of Top 12 companies with Market Capitalization of more than $25 billion in the Utilities Sector.

utilities-sector-profitability

source: ycharts

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