Profit Margin Ratio

Every company needs to carry out a detailed examination of its financial statements from time to time, in order to ascertain its fiscal health. The ultimate goal of every company is to earn 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, it is easy to get carried away, so one needs to look at the actual profit derived in such a situation. This analysis is useful in comparing the company's state of affairs with competitors in the same industry, and one can also judge the growth of the same company over a period of time.

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.

By applying this formula, the company can then proceed to determine how much profit it is making for each dollar of sales. 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 profitability.

Suppose, a company named ABC Inc. has total sales figures of USD 100,000 for a given period. In the same period, their net income (after taxes and other deductions) is USD 10,000. This means that their ratio is 10,000 / 100,000, or 10%. This further implies that for every dollar of sales that they made, the profit is USD 0.10.

Now, another company named XYZ Inc. functions in the same market and has total sales of USD 300,000. At first glance one would think that this company is more profitable. But their net income is only USD 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 USD 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 increasing sales for a period of say, two years, the rise or drop in the profit margin is what they should really be looking at. This will provide an accurate indication of improvement in their operations and profitability.

You may have also heard of the terms, net and gross profit ratios, without knowing the exact difference between the two. Net profit simply implies the net value after all expenses and taxes have been subtracted from the gross profit.

By comparing these two ratios, the company can also determine the effect that the various expenses have on the profitability. These include taxes, interest, salaries, overhead expenses, and other miscellaneous charges.

It also provides the company some indicators about its efficiency. A rising gross margin indicates that trading and marketing activities are doing well, whereas a rising net margin indicates that the company is managing its expenses and day-to-day operations efficiently.

There are many calculators that you can locate on the Internet, which will help you calculate this ratio accurately. Small businesses typically make use of them, but medium-sized and large businesses have a finance department or an external firm to handle the accounting.