Profit margin is not a particularly complex ratio but is considered to be one of the most important indications of the efficiency of a business. There are many factors that influence profit margins, but not all of them are quantitative and therefore are not obviously reflected in your calculation's variables.
If you are a retailer, for instance, your branding and marketing strategy affect your profit margin indirectly through revenues. In a way, nearly all aspects of your company's operations – from management down to floor sales tactics – affect your profit margin.
What Is Profit Margin?
There are different types of profit margin – gross versus net – but this description focuses on net profit margin because there are more factors that influence net profits.
Net profit margin is the ratio of net income relative to revenues, calculated by simply dividing profits by sales. This is a quick way to determine what percentage of your sale price that your company keeps after accounting for the costs that went into the sale.
Net Margin = Net Profit / Revenue.
Net profit margin is a better representation of financial health than revenues alone. It is possible to increase your company's earnings while decreasing your profit margin, meaning that the company is becoming relatively less efficient. It is impossible to have a net profit margin if your company is losing money.
The most obvious, easily identifiable and broad numbers that affect your profit margin are your net profits, your sales earnings, and your merchandise costs. On your income statement, look at net revenues and cost of goods sold, for instance, for a very general view of these major variables.
Dig a little deeper, and sales prices become very important factors. Increase your net profit margin by doing a good job of managing your merchandise costs, and you can increase your sales prices at the same time.
Inventory numbers matter, too. Even though inventory is recorded as an asset on the balance sheet, you do not record sales revenues until the transaction has actually taken place. Devalued inventory can hurt profit margins, and getting rid of inventory through increased sales can help profit margins.
There are too many qualitative factors to list in a short article, but consider all of the elements that might affect the sale of any given product, such as market share, effective advertising, seasonal changes, consumer preferences, company leadership, sales reward programs, training programs for employees and the competition's strength.
The Bottom Line
Many analysts and investors take profit margin so seriously because it can contain an enormous amount of information about a company into one efficient, easy-to-understand number.