Profit margins are perhaps the simplest and most widely used financial ratios in corporate finance. A company's profit is calculated at three levels on its income statement, starting with the most basic – gross profit – and building up to the most comprehensive – net profit. Between these two lies operating profit. All three have corresponding profit margins calculated by dividing the profit figure by revenue and multiplying by 100.
Gross profit is the simplest profitability metric because it defines profit as all income that remains after accounting for the cost of goods sold (COGS). COGS includes only those expenses directly associated with the production or manufacture of items for sale, including raw materials and wages for labor required to make or assemble goods. Excluded from this figure are, among other things, any expenses for debt, taxes, operating or overhead costs, and one-time expenditures such as equipment purchases. The gross profit margin compares gross profit to total revenue, reflecting the percentage of each revenue dollar that is retained as profit after paying for the cost of production.
A slightly more complex metric, operating profit also takes into account all overhead, operating, administrative and sales expenses necessary to run the business on a day-to-day basis. While this figure still excludes debts, taxes and other non-operational expenses, it does include the amortization and depreciation of assets. By dividing operating profit by revenue, this mid-level profitability margin reflects the percentage of each dollar that remains after payment for all expenses necessary to keep the business running.
How to Calculate Profit Margins
The infamous bottom line, net income, reflects the total amount of revenue left over after all expenses and additional income streams are accounted for. This includes COGS and operational expenses as referenced above, but it also includes payments on debts, taxes, one-time expenses or payments, and any income from investments or secondary operations. The net profit margin reflects a company's overall ability to turn income into profit.
For the fiscal year ended October 2016, Starbucks Corp (SBUX) recorded revenue of $21.32 billion. Gross profit and operating profit clock in at healthy figures of $12.8 billion and $4.17 billion respectively. The net profit for the year is $2.82 billion. The profit margins for Starbucks would therefore be calculated as:
Gross profit margin = ($12.8 billion ÷ $21.32 billion) x 100 = 60.07%.
Operating profit margin = ($4.17 billion ÷ $21.32 billion) x 100 = 19.57%.
Net profit margin = ($2.82 billion ÷ $21.32 billion) x 100 = 13.22%.
This example illustrates the importance of having strong gross and operating profit margins. Weakness at these levels indicates that money is being lost on basic operations, leaving little revenue for other expenses. The healthy gross and operating profit margins in the above example enabled Starbucks to maintain decent profits while still meeting all of its other financial obligations.
For business owners, profitability metrics are important because they highlight points of weakness in the operational model and enable year-to-year performance comparison. For investors, a company's profitability has important implications for its future growth and investment potential. In addition, this type of financial analysis allows both management and investors to see how the company stacks up against the competition.