The following ratios are used to analyze and compare financial statements. We will discuss each in more detail below.

7.5: Profit Margin = Net income ÷ sales7.6: Operating Margin = Operating income ÷ net sales7.7: Interest Coverage Ratio = EBIT ÷ annual debt interest payments7.8: Price-Earnings Ratio = Market value per share ÷ earnings per share7.9: Price-to-Book Ratio = Current closing price of stock ÷ book value per share.(Where book value = total assets - intangible assets and liabilities)

Formula 7.5: Profit Margin measures how much out of every dollar in sales a company actually keeps in earnings. Profit margin is very useful when comparing companies in similar industries. A higher profit margin, compared to other industry competitors, indicates a more profitable company that has better control over its costs. Profit margin is displayed as a percentage. A 20% profit margin, for example, means that the company has a net income of 20 cents for each dollar of sales.Example: ABC Manufacturing reports quarterly net income of $4.4 million on sales of $25 million.

Profit margin = $4,400,000 / $25,000,000 = .176 or 17.6%

Look Out!Looking at the earnings of a company often doesn\'t tell the entire story. Increased earnings are good, but an increase does not mean that the profit margin of a company is improving. For instance, if a company has costs that have increased at a greater rate than sales, it leads to a lower profit margin. This is an indication that costs need to be under better control.

Imagine a company has a net income of $15 million from sales of $100 million, giving it a profit margin of 15% ($15 million/$100 million). If in the next year net income rose to $20 million on sales of $200 million, its profit margin would fall to 10%. So while the company increased its net income, it has done so with diminishing profit margins.Formula 7.6: Operating Margin allows you to compare a company's efficiency, or quality of operations, to that of other companies. This ratio is essentially the same as Profit Margin, except only income from operations is considered. Operating margin is a measurement of what proportion of a company's revenue is left over after paying for variable costs of production, such as wages, raw materials, etc. A healthy operating margin is required for a company to be able to pay for its fixed costs, such as interest on debt.Example: XYZ Technology reports an annual operating profit of $89 million on net sales of $345 million. What is its operating margin?

Operating margin = $89,000,000 / $345,000,000 = .258 or 25.8%

Look Out!Operating margin gives analysts an idea of how much a company makes (before interest and taxes) on each dollar of sales. When looking at operating margin to determine the quality of a company, it is best to look at the change in operating margin over time and to compare the company's yearly or quarterly figures to those of its competitors. If a company's margin is increasing, it is earning more per dollar of sales. The higher the margin, the better.

The article, The Bottom Line On Margins takes a deeper look at a company's profitability and profit margin ratios.

The Income Statement: Key Ratios

Related Articles
  1. Investing

    A Look At Corporate Profit Margins

    Take a deeper look at a company's profitability with the help of profit margin ratios.
  2. Investing

    Profitability Indicator Ratios

    Learn about profit margin analysis, effective tax rate, return on assets, return on equity and return on capital employed.
  3. Investing

    The Difference Between Gross and Net Profit Margin

    To calculate gross profit margin, subtract the cost of goods sold from a company’s revenue; then divide by revenue.
  4. Managing Wealth

    What's a Good Profit Margin for a Mature Business?

    How to determine if the amount you clear dovetails with the competition.
  5. Investing

    Buying on Margin

    When an investor buys on margin, he or she pays a portion of the stock price – called the margin -- and borrows the rest from a stockbroker. The purchased stocks then serve as collateral for ...
  6. Investing

    Explaining Initial Margin

    Initial margin is the percentage of a stock’s price an investor must have in his account to buy that stock on margin.
Frequently Asked Questions
  1. What's the Best Way to Contact Warren Buffett?

    Learn how to contact Warren Buffett and what kinds of contact is most likely to receive a response from him or from his company, ...
  2. What is the Financial Services Sector?

    A diverse group of companies, beyond banks and credit unions, comprises the financial services sector.
  3. Who are Whole Foods' (WFM) main competitors?

    Whole Foods' main competitors are Sprouts Farmers Markets and Trader Joe's. However, the recent acquisition by Amazon my ...
  4. What caused the Stock Market Crash of 1929 that preceded the Great Depression?

    Find out what led to the stock market crash of 1929, which in turn led to the Great Depression. It sparked a nearly 90% loss ...
Trading Center