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!
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
- The ratio measures the gross profit ratio on the total sales made by the company.
- The gross profit represents the excess of sales proceeds during the period under observation over their cost, before taking into account administration, selling and distribution, and financing chargesFinancing ChargesThe finance charge, also known as the cost of borrowing or cost of credit, is the accrued interest or fees that have been charged on the approved credit facility. Usually, this charge is a flat fee, but most of the time it is a percentage of the amount borrowed on an extended line of credit.. The ratio measures the efficiency of the company’s operations, and this can also be compared with the previous years’ results to ascertain the efficiency.
- When everything is normal, the gross margin of profit should remain unchanged, irrespective of the level of production and sales, as it stands on the hypothesis that while computing gross profit ratioGross Profit RatioThe gross profit ratio evaluates the proportion of the direct profit a company generates from its net sales. Here, the gross profit is the returns acquired after considering the cost of goods sold, trade discounts and sales returns for deduction from the total revenue., all expenditures are to be subtracted, which are directly volatile with 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.
- 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.
- 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.
source: 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
- This ratio reflects the net margin on profit on the total sales after deducting all expenses covering interest and taxation too.
- One important point that we should note here is that Net margin can increase or decrease due to the presence of non-recurring itemsNon-recurring ItemsNon-recurring items are income statement entries that are unusual and unexpected during regular business operations; examples include profits or losses from sale of asset, impairment costs, restructuring costs, and losses in lawsuits, and inventory write-off..
- It is, therefore, important to take those into account before we come to any conclusion.
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.
- 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%)
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. = $ 48,000 * 150 / 100 = $ 72,000
Calculation of Profits
|Less: Direct costs||48,000|
|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 %
Z Ltd. has the following information
|Particulars||Year 1||Year 2|
|Gross margin||21 %||20 %|
|Operating margin||15 %||15 %|
|Net Margin||10 %||11 %|
You are required to interpret and analyzed the changes in profitability margin
Solution to Profit Margin – Example 2
|Gross margin||Decrease||The 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 Margin||Constant||The remaining Constant of operating margin indicates in spite of the decline of gross margin; the company has benefitted in terms of operating performance.|
|Net margin||Increase||Enhancing 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.
- 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.
source: 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.
- The average Gross Margin for this utility peer group is around 51.9%, the Average EBIT Margin is at 19.0%, and the Net Margin is at 10.6%
- We note that the Highest Gross Margins for the Utility sector is less than that of the Technology Sector. It is expected primarily due to higher Direct costs (manufacturing, raw material, transmission, etc.) associated with the Utility sector.
- Engiy (ticker – ENGIY) is the only company that has a negative EBIT Margin (~4.6%) and a negative net margin (~6.6)
- American Electric, Dominion Resources, and Duke Energy has a robust Gross Profit MarginGross Profit MarginGross Profit Margin is the ratio that calculates the profitability of the company after deducting the direct cost of goods sold from the revenue and is expressed as a percentage of sales. It doesn’t include any other expenses into account except the cost of goods sold. (> 60%), EBIT Margins (>20%), and Net Margins (>12%)