Profit Margin

Profit margin is a measure of profitability that expresses profit as a percentage of revenue. It shows how many cents of each dollar of sales a company keeps after paying its costs. Because it is a ratio, it allows companies of different sizes to be compared, and it allows a single company's performance to be tracked over time. When used without qualification, "profit margin" usually means net profit margin, based on net income.

There are three main versions, each corresponding to a level of the income statement. Analysts use them together to see where in the business profit is being made or lost: in production and purchasing, in overhead, or through financing and taxes.

Net profit margin, the headline measure, is:

Here $\text{Net income}$ is profit after all expenses, interest and taxes, and $\text{Revenue}$ is net sales for the same period. The other two margins use the same denominator:

• Gross margin: gross profit (revenue minus cost of goods sold) divided by revenue. It reflects pricing power and the cost of producing or buying what is sold.
• Operating margin: operating income divided by revenue. It also reflects selling, general and administrative costs and research spending, and is close to EBIT margin.
• Net margin: net profit divided by revenue, after interest, taxes and one-off items.

A sportswear company reports revenue of $500,000,000, cost of goods sold of $275,000,000, operating expenses of $160,000,000, interest expense of $15,000,000 and income tax of $12,500,000.

• Gross profit is $225,000,000, a gross margin of 45 percent.
• Operating income is $65,000,000, an operating margin of 13 percent.
• Net income is $65,000,000 minus $15,000,000 minus $12,500,000, or $37,500,000, a net margin of 7.5 percent.

If a rival has a similar gross margin but a net margin of only 4 percent, the difference lies in overhead, interest or tax rather than in product costs. Converting the full income statement into a common-size income statement shows each cost as a percentage of revenue and makes such comparisons easier.

Profit margin is one of the three parts of the DuPont analysis of return on equity (ROE):

Here $\text{Asset turnover}$ is revenue divided by average total assets and $\text{Equity multiplier}$ is average total assets divided by average equity. A business can reach the same return with a low margin and fast asset turnover, like a discount retailer, or with a high margin and slower turnover, like a luxury goods maker.

Typical margins vary widely by industry. Grocery retailers often earn net margins of 1 to 3 percent, while software and pharmaceutical companies can exceed 20 percent. Margins should therefore be compared within an industry and over several years. Limitations include:

• One-off gains and charges can distort net margin, so analysts often look at adjusted or operating margins.
• Differences in accounting policies, such as depreciation methods or inventory costing, affect comparability.
• Margin says nothing about the amount of capital needed to earn the profit, which is why it is paired with return on assets and similar measures.
• A high margin on falling sales can hide a shrinking business, while a temporary margin squeeze may reflect deliberate investment in growth.

Measures such as EBITDA margin remove depreciation and amortization to compare cash-generating ability, but they ignore the cost of replacing assets.