The most widely used financial margins are calculated based on income statements and include metrics such as gross profit margin, operating profit margin, net income margin, EBITDA margin and contribution margin. Investors also use margins based on cash flows, including the operating cash flow margin. Finally, analysts often calculate industry-specific margins, such as net interest margin for the companies in the banking sector.

When an investor considers investing in a company, he should pay special attention to financial margins. These ratios demonstrate the company's ability to contain its costs and generate profits and cash flows that it can use to make capital investments or payouts in the form of dividends or share buybacks. Margins are presented in percentage terms and provide for better comparisons across different time periods for a company. An investor can also compare a company's margins against its industry peers.

An income statement contains four levels of profitability margins based on gross profits, operating income, earnings before taxes and net income. These margins convey how much profits the company generated as a percent of sales. Gross profit margin tells investors if the company's average markup on goods and services covers its cost of goods sold (COGS).

Operating income margin indicates the company's ability to cover its production costs as well as sales, general and administrative expenses, and research and development expenditures. Operating income margin is a widely used metric; the operating income represent pretax money based on accrual accounting available to the company's common shareholders and creditors.

Investors often use the earnings before taxes margin to gauge how much profits the company generated before paying out a portion of its earnings to tax authorities. Common shareholders pay special attention to net income margin, because this metric assesses the company's effectiveness to generate earnings for its shareholders.

Other popular margins among investors include EBITDA margin and contribution margin. EBITDA margin measures how much profits the company earned as a percent of revenue before paying out any interest, taxes, depreciation and amortization. This margin is similar to cash flow margin, since depreciation and amortization do not represent cash outflows. Operating cash flow margin is another important metric that reveals how much cash flow from operations as a percent of revenues the company generated in a given period.

Contribution margin is calculated as the revenues minus variable costs divided by the total revenue. The contribution margin provides investors with a measure of the operating leverage present in the company. Typically, companies with high contribution margins have higher degrees of operating leverage and are considered very risky. This metric is sometimes difficult to calculate; very few companies disclose the breakdown of their costs between variable and fixed components.

Analysts calculate industry-specific financial margins, such as net interest margin for companies in the banking sector. Calculated as interest income minus interest expense divided by the bank's loans to customers, net interest margin is most helpful in gauging the bank's ability to generate income on its core operating assets.

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  2. What is the difference between operating margin and profit margin?

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