All businesses aim to maximize their profits, minimize their expenses and maximize their market share. Here is a look at each of these goals.
A company's most important goal is to make money and keep it. Profit-margin ratios are one way to measure how much money a company squeezes from its total revenue or total sales.
There are three key profit-margin ratios: gross profit margin, operating profit margin and net profit margin.
1. Gross Profit Margin
The gross profit margin tells us the profit a company makes on its cost of sales or cost of goods sold. In other words, it indicates how efficiently management uses labor and supplies in the production process.
Gross Profit Margin = (Sales - Cost of Goods Sold)/Sales
Suppose that a company has $1 million in sales and the cost of its labor and materials amounts to $600,000. Its gross margin rate would be 40% ($1 million - $600,000/$1 million).
The gross profit margin is used to analyze how efficiently a company is using its raw materials, labor and manufacturing-related fixed assets to generate profits. A higher margin percentage is a favorable profit indicator.
Gross profit margins can vary drastically from business to business and from industry to industry. For instance, the airline industry has a gross margin of about 5%, while the software industry has a gross margin of about 90%.
2. Operating Profit Margin
By comparing earnings before interest and taxes (EBIT) to sales, operating profit margins show how successful a company's management has been at generating income from the operation of the business:
Operating Profit Margin = EBIT/Sales
If EBIT amounted to $200,000 and sales equaled $1 million, the operating profit margin would be 20%.
This ratio is a rough measure of the operating leverage a company can achieve in the conduct of the operational part of its business. It indicates how much EBIT is generated per dollar of sales. High operating profits can mean the company has effective control of costs, or that sales are increasing faster than operating costs. Positive and negative trends in this ratio are, for the most part, directly attributable to management decisions.
Because the operating profit margin accounts for not only costs of materials and labor, but also administration and selling costs, it should be a much smaller figure than the gross margin.
3. Net Profit Margin
Net profit margins are those generated from all phases of a business, including taxes. In other words, this ratio compares net income with sales. It comes as close as possible to summing up in a single figure how effectively managers run the business:
Net Profit Margins = Net Profits after Taxes/Sales
If a company generates after-tax earnings of $100,000 on its $1 million of sales, then its net margin amounts to 10%.
Often referred to simply as a company's profit margin, the so-called bottom line is the most often mentioned when discussing a company's profitability.
The Agency Problem
Again, just like gross and operating profit margins, net margins vary between industries. By comparing a company's gross and net margins, we can get a good sense of its non-production and non-direct costs like administration, finance and marketing costs.
For example, the international airline industry has a gross margin of just 5%. Its net margin is just a tad lower, at about 4%. On the other hand, discount airline companies have much higher gross and net margin numbers. These differences provide some insight into these industries' distinct cost structures: compared to its bigger, international cousins, the discount airline industry spends proportionately more on things like finance, administration and marketing, and proportionately less on items such as fuel and flight crew salaries.
In the software business, gross margins are very high, while net profit margins are considerably lower. This shows that marketing and administration costs in this industry are very high, while cost of sales and operating costs are relatively low.
When a company has a high profit margin, it usually means that it also has one or more advantages over its competition. Companies with high net profit margins have a bigger cushion to protect themselves during the hard times. Companies with low profit margins can get wiped out in a downturn. And companies with profit margins reflecting a competitive advantage are able to improve their market share during the hard times, leaving them even better positioned when things improve again.
Like all ratios, margin ratios never offer perfect information. They are only as good as the timeliness and accuracy of the financial data that gets fed into them, and analyzing them also depends on a consideration of the company's industry and its position in the business cycle. Margins tell us a lot about a company's prospects, but not the whole story.
Companies use cost controls to manage and/or reduce their business expenses. By identifying and evaluating all of the business's expenses, management can determine whether those costs are reasonable and affordable. Then, if necessary, they can look for ways to reduce costs through methods such as cutting back, moving to a less expensive plan or changing service providers. The cost-control process seeks to manage expenses ranging from phone, internet and utility bills to employee payroll and outside professional services.
To be profitable, companies must not only earn revenues, but also control costs. If costs are too high, profit margins will be too low, making it difficult for a company to succeed against its competitors. In the case of a public company, if costs are too high, the company may find that its share price is depressed and that it is difficult to attract investors.
When examining whether costs are reasonable or unreasonable, it's important to consider industry standards. Many firms examine their costs during the drafting of their annual budgets.
Maximize Market Share
Market share is calculated by taking a company's sales over a given period and dividing it by the total sales of its industry over the same period. This metric provides a general idea of a company's size relative to its market and its competitors. Companies are always looking to expand their share of the market, in addition to trying to grow the size of the total market by appealing to larger demographics, lowering prices or through advertising. Market share increases can allow a company to achieve greater scale in its operations and improve profitability.
The size of a market is always in flux, but the rate of change depends on whether the market is growing or mature. Market share increases and decreases can be a sign of the relative competitiveness of the company's products or services. As the total market for a product or service grows, a company that is maintaining its market share is growing revenues at the same rate as the total market. A company that is growing its market share will be growing its revenues faster than its competitors. Technology companies often operate in a growth market, while consumer goods companies generally operate in a mature market.
New companies that are starting from scratch can experience fast gains in market share. Once a company achieves a large market share, however, it will have a more difficult time growing its sales because there aren't as many potential customers available.
Next we'll take a look at the potential conflicts of interest that can arise in the management of a business's finances.