Calculating a profit margin is not particularly complex but it is considered to be one of the most important indicators of the viability of a business to continue to exist as a going concern. 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.
- The most direct factor that affects profit margins is your net or gross profit.
- One of the easiest and fastest ways to adjust profit margins is to adjust the sale price of a product or service.
- While most margins can be explained quantitatively, external factors such as consumer sentiment, halo effect, and other emotional factors can factor in as well.
What Is a Profit Margin?
There are different types of profit margin (e.g. gross vs. net) but this description focuses on net profit margin because there are more factors that influence net profits.
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.
Net profit margin is the ratio of net income relative to revenues, calculated by simply dividing net profit (or net income—the bottom line in the income statement) by sales (or revenue). 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 Profit Margin = Net Income / Sales
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. When the company is losing money, net profit margin does not exist, rather, the company has a net loss.
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 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.