Profit margins are financial ratios used to determine your business’s profitability. Different profit margin ratios correspond to the reflected profit in a company’s income statement: gross, operating, and net. They are calculated simply by dividing the profit value by the total sales and multiplying it by 100, as profit margins are expressed in percent.
They are also used to analyze cost efficiency for production, competitiveness against industry standards and competitors, and progress or profit trend of the company over time.
Gross Profit Margin
The gross profit margin reflects the profit as a percentage per pound revenue after paying for the cost of production.
Gross profit margin (%) = [(Revenue – COGS) ÷ Revenue] x 100
Gross profit is the most straightforward profitability metric, defining profit as all income that remains after accounting for the cost of goods sold (COGS). COGS include expenses directly involved in manufacturing the products sold by the company. These are raw materials, direct labour, and manufacturing overhead.
Other business expenses such as debts, taxes, operating expenses, and one-time expenditures such as purchasing new equipment are excluded.
The gross profit margin is used to analyze the business’s efficiency in utilizing its inventory to generate profit. You can also use it to compare your business’s competitiveness when it comes to your production efficiency and profitability against your competitors.
Operating Profit Margin
Operating profit is slightly more complex. It accounts for business operating expenses such as overheads, administrative costs, and sales expenses. These expenses are necessary to run the business daily but exclude debts, taxes, and non-operational expenses. Operating profit is also often called earnings before interest and taxes (EBIT).
Calculating the operating profit margin is easy once you’ve accounted for the operating income.
Operating profit margin (%) = (Operating Income ÷ Revenue) x 100
Operating profit margin is also known as return on sales and is often used to analyze how well business operation is managed and how risky it is. Lenders pay close attention to a company’s operating margin, as it shows the portion of revenue that is available to cover non-operating costs. Businesses with highly variable operating profit margins can be an indication of risk.
Analysis of operating profit margin is limited to comparing businesses in the same industry, and ideally with similar business models and annual sales.
Net Profit Margin
The net profit comes in many names, but the two most famous are net income and the bottom line. It reflects the amount of revenue left after all expenses, taxes, and other income streams are accounted for and appear at the bottom line of your business’s income statement, hence the name.
Expenses accounted for include COGS, operational costs, non-operational expenses such as debts, and one-time payments, and taxes. Net income also includes other streams of income apart from sales, such as investments and secondary operations.
In other words, the net profit margin reflects the company’s overall ability to turn income into profits. It’s formula is:
Net profit margin (%) = [(Revenue – COGS – Operational expenses – Other expenses – Debts – Taxes) ÷ Revenue] x 100
Net profit margin (%) = (Net income ÷ Revenue) x 100
The net profit margin considers all business activities from total revenue to all outgoing cash flow, as well as alternative sources of income. It is one of the most important indicators of your business’s financial health.
Profit margins are tools of comparison that analyze your business’s financial health. Its analysis is optimized when used for comparing business competitors in the same industry with similar business models. The different levels of profit margins also reflect the financial health and management of different business activity levels.
The gross profit margin looks into the profitability of your business at the production level. The operational profit margin takes into account the profitability of your business at your day-to-day operational level. Lastly, the net profit margin gives you an overview of the business’s overall profitability.
The higher your profit margin is, the better your business performs when it comes to generating profits. However, it is also a matter of maintaining that margin over time, especially for operational profit margins.
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