What is Profit Margin?
The term “profit margin” refers to the profitability measure that assesses the financial benefit earned relative to the overall sales. In other words, the metric gauges what portion of the sales has been converted into profit or how much profit have been generated for each dollar of sale. There are several types of profit margin metric and some of its major variants are:
- Gross Profit Margin(GPM)
- Operating Income Margin
- Net Income Margin
Formula
The formula for profit margin can be derived by dividing the difference of the total sales and its associated total expenses by the total sales and then expressed in terms of percentage. Mathematically, it is represented as,
It is to be noted that the total expenses are an umbrella term that will include of cost of sales for gross profit margin, operating expenses for operating profit margin and all the expenses for net profit margin.
Examples of Profit Margin (With Excel Template)
Let’s take an example to understand the calculation of Profit Margin in a better manner.
Example #1
Let us take the example of an entity ASD Inc. that is into the business of the retail food chain. During the year ended on December 31, 2018, the company has achieved total sales of $10.0 million, while incurring a cost of sales of $5.6 million, selling & administrative expenses of $1.5 million, interest expense of $0.8 million and taxes of $1.0 million. Calculate the gross profit margin, operating income profit, net income margin of the company for the year 2018 based on the given information.
Solution:
Operating Expenses is calculated using the formula given below
Operating Expenses = Cost of Sales + Selling & Administration Expenses
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- Operating Expenses = $5.6 million + $1.5 million
- Operating Expenses = $7.1 million
Total Expenses is calculated using the formula given below
Total Expenses = Operating Expenses + Interest Expense + Taxes
- Total Expenses = $7.1 million + $0.8 million + $1.0 million
- Total Expenses = $8.9 million
Gross Profit Margin is calculated using the formula given below
GPM = (Total Sales – Cost Sales) / Total Sales * 100
- GPM = ($10.0 million – $5.6 million) / $10.0 sales * 100
- GPM = 44%
Operating Income Margin is calculated using the formula given below
Operating Income Margin = (Total Sales – Operating Expenses) / Total Sales * 100
- Operating Income Margin = ($10.0 million – $7.1 million) / $10.0 sales * 100
- Operating Income Margin = 29%
Net Income Margin is calculated using the formula given below
Net Income Margin = (Total Sales – Total Expenses) / Total Sales * 100
- Net Income Margin = ($10.0 million – $8.9 million) / $10.0 sales * 100
- Net Income Margin = 11%
Therefore, the GPM, operating income profit, net income margin of the company for the year 2018 stood at 44.0%, 29.0%, and 11.0% respectively.
Example #2
Let us take the example of Walmart Inc. to illustrate the concept of profit margin for a real-life company. According to the annual report for the year 2018, the following information is available,
Calculate gross profit margin, operating income profit, net income margin of Walmart Inc. for the year 2018 based on the given information.
Solution:
Operating Expenses is calculated using the formula given below
Operating Expenses = Cost of Sales + Operating and SG&A Expenses
- Operating Expenses = $373.40 billion + $106.51 billion
- Operating Expenses = $479.91 billion
Total Expenses is calculated using the formula given below
Total Expenses = Operating Expenses + Net Interest Expense + Loss on Extinguishment of Debt + Provision for Income Taxes
- Total Expenses = $479.91 billion + $2.18 billion + $3.14 billion + $4.60 billion
- Total Expenses = $489.83 billion
Gross Profit Margin is calculated using the formula given below
GPM = (Total Revenue – Cost Sales) / Total Revenue * 100
- GPM = ($500.34 billion – $373.40 billion) / $500.34 billion * 100
- GPM = 25.4%
Operating Income Margin is calculated using the formula given below
Operating Income Margin = (Total Revenue – Operating Expenses) / Total Revenue * 100
- Operating Income Margin = ($500.34 billion – $479.91 billion) / $500.34 billion * 100
- Operating Income Margin = 4.1%
Net Income Margin is calculated using the formula given below
Net Income Margin = (Total Revenue – Total Expenses) / Total Revenue * 100
- Net Income Margin = ($500.34 billion – $489.83 billion) / $500.34 billion * 100
- Net Income Margin = 2.1%
Therefore, the GPM, operating income profit, net income margin of Walmart Inc. for the year 2018 stood at 25.4%, 4.1%, and 2.1% respectively.
Source Link: Walmart Inc. Balance Sheet
Advantages
Some of the advantages are as follows:
- It indicates the cost efficiency of a company and helps track its performance across time periods.
- It helps in assessing the financial health of a company and facilitates peer comparison on that basis.
Limitations
Some of the limitations are as follows:
- If used to compare companies across different industries or sectors, then the profit margin may lead to meaningless insights.
- It is exposed to the risk of manipulation.
Conclusion
So, it can be concluded that profit margins are the most important metrics for financial analysis as it indicates the cost efficiency of a company that can be used for trend analysis and peer comparison. However, one has to be careful while using the margins as they can be manipulated to reflect overstated margins.
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