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# Profit Margin Defined: How to Calculate and Compare

## What Is Profit Margin?

Profit margin is one of the commonly used profitability ratios to gauge the degree to which a company or a business activity makes money. It represents what percentage of sales has turned into profits. Simply put, the percentage figure indicates how many cents of profit the business has generated for each dollar of sale. For instance, if a business reports that it achieved a 35% profit margin during the last quarter, it means that it had a net income of $0.35 for each dollar of sales generated. There are several types of profit margin. In everyday use, however, it usually refers to net profit margin, a company’s bottom line after all other expenses, including taxes and one-off oddities, have been taken out of revenue. ### Key Takeaways • Profit margin gauges the degree to which a company or a business activity makes money, essentially by dividing income by revenues. • Expressed as a percentage, profit margin indicates how many cents of profit has been generated for each dollar of sale. • While there are several types of profit margin, the most significant and commonly used is net profit margin, a company’s bottom line after all other expenses, including taxes and one-off oddities, have been removed from revenue. • Profit margins are used by creditors, investors, and businesses themselves as indicators of a company's financial health, management's skill, and growth potential. • As typical profit margins vary by industry sector, care should be taken when comparing the figures for different businesses. 2:07 #### Understanding Profit Margin ## Understanding Profit Margin Businesses and individuals across the globe perform for-profit economic activities with the aim to generate profits. However, absolute numbers—like$X million worth of gross sales, $Y thousand business expenses, or$Z earnings—fail to provide a clear and realistic picture of a business's profitability and performance. Several different quantitative measures are used to compute the gains (or losses) a business generates, which makes it easier to assess the performance of a business over different time periods or compare it against competitors. These measures are called profit margins.

While proprietary businesses, like local shops, may compute profit margins at their own desired frequency (like weekly or fortnightly), large businesses including listed companies are required to report it in accordance with the standard reporting timeframes (like quarterly or annually). Businesses that may be running on loaned money may be required to compute and report it to the lender (like a bank) on a monthly basis as a part of standard procedures.

There are four levels of profit or profit margins:

These are reflected on a company's income statement in the following sequence: A company takes in sales revenue, then pays direct costs of the product or service. What’s left is the gross margin. Then it pays indirect costs like company headquarters, advertising, and R&D. What’s left is the operating margin. Then it pays interest on debt and adds or subtracts any unusual charges or inflows unrelated to the company’s main business with a pre-tax margin left over. Then it pays taxes, leaving the net margin, also known as net income, which is the very bottom line.

There are other key profitability ratios that analysts and investors commonly use to determine the financial health and well-being of a company. The return on assets (ROA) analyzes how well a company deploys its assets to generate a profit after factoring in expenses. A company's return on equity (ROE) determines a company's return based on its equity investments.

## Types of Profit Margin

Let's look more closely at the different varieties of profit margins.

### Gross Profit Margin

Gross profit margin: Start with sales and take out costs directly related to creating or providing the product or service like raw materials, labor, and so on—typically bundled as "cost of goods sold,” “cost of products sold,” or “cost of sales” on the income statement—and you get gross margin. Done on a per-product basis, gross margin is most useful for a company analyzing its product suite (though this data isn’t shared with the public), but aggregate gross margin does show a company’s rawest profitability picture. As a formula:

﻿ \begin{aligned} &\textit{Gross profit margin}=\frac{\textit{Net sales }-\textit{ COGS}}{\textit{Net sales}}\\ &\textbf{where:}\\ &\textit{COGS}=\text{cost of goods sold} \end{aligned}﻿

### Operating Profit Margin

Operating Profit Margin or just operating margin: By subtracting selling, general and administrative, or operating expenses, from a company's gross profit number, we get operating profit margin, also known as earnings before interest and taxes, or EBIT.

This results in an income figure that’s available to pay the business' debt and equity holders, as well as the tax department, its profit from a company’s main, ongoing operations. it’s frequently used by bankers and analysts to value an entire company for potential buyouts. As a formula:

$\textbf{Operating Profit Margin}=\frac{\textbf{Operating Income}}{\textbf{Revenue}}\ \mathbf{\times\ 100}$

### Pretax Profit Margin

Pretax profit margin: Take operating income and subtract interest expense while adding any interest income, adjust for non-recurring items like gains or losses from discontinued operations, and you’ve got pre-tax profit, or earnings before taxes (EBT). Divide this figure by revenue, and you've got the pretax profit margin.

## What's the Difference Between Gross Profit Margin and Operating Profit Margin?

Gross profit margin refers to a company's net sales less the total cost of goods sold. This metric shows how much of a profit a company makes before any deductions are made, including general and administrative costs. Operating profit margin, on the other hand, refers to any profit that a company makes after it pays for certain variable costs, such as wages and raw materials.

## The Bottom Line

There are many different metrics that analysts and investors can use to help them determine whether a company is financially healthy and sound. One of these is the profit margin. It does this by taking the sales that a company converts into a profit and turning it into a percentage. In simpler terms, a company's profit margin is the total number of cents per dollar earned on a sale that the company keeps as a profit.

These margins can be divided into different categories, such as gross and operating profit margins. But the most common is the net profit margin, which is what we normally call a company's bottom line. This figure is what's left after any taxes and any other expenses have been deducted.