How to analyze profit margins

Written by john gugie
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Profits are important to companies and investors. A consistently high profit usually means efficient management and a good investment, bringing in more capital and growth. Profit margins are financial ratios that tell investors how profitable companies are with different types of costs. Profits can be misleading, so investors need margins to make informed investments. There are three major profit margins, including Gross, Operating, and Net Profit Margin. (see Resources below)

Skill level:
Moderate

Instructions

1. 1

Calculate the Gross Profit Margin. The company's sales and cost of goods sold are required. Sales are the value of products sold by the company. Costs of goods sold are the production expenses, including labour, materials and manufacturing overhead. The formula to calculate gross profit margin is Gross Profit Margin = (Sales - Cost of Goods Sold) / Sales. Our example uses sales of £2,600,000 and a cost of goods sold of £650,000, resulting in Gross Profit Margin = (4,000,000 - 1,000,000) / 4,000,000 = 3,000,000 / 4,000,000 = 75%.

2. 2

Analyse the Gross Profit Margin. This figure reveals a company's profits after paying its fixed costs of production. This shows how efficiently a company manages its fixed costs to generate profits. The higher this figure, the more liquid the company's cash flow, resulting in more money to use on future costs and reinvestment. Investors want a consistently high gross profit margin because it shows that the company is profitable. (see Resources below) Our example company has a gross profit margin of 75 per cent, which is very good but other margins are required to determine how other costs affect the company's profits.

3. 3

Calculate the Operating Profit Margin. The company's sales and earnings before interest and taxes are required. The formula to calculate operating profit margin is Operating Profit Margin = Earnings before Interest &amp; Taxes / Sales. Our example uses sales of £2,600,000 and earnings before interest and taxes of £487,500, resulting in Operating Profit Margin = 750,000 / 4,000,000 = 19%.

4. 4

Analyse the Operating Profit Margin. This figure reveals a company's profits after it pays its variable costs of production, administration, selling, and operating expenses. This shows the efficiency of the company to manage its business operations to earn profits and its ability to pay for its fixed costs, like interest. Investors want a company with consistently high operating profit margins because it shows more liquidity and that sales are increasing faster than costs, which can mean growth. Since companies have more control over operating expenses than its cost of goods sold, it is important to examine this figure carefully because it is directly affected by management decisions. (see Resources below) Our example company has an operating profit margin of 19 per cent, which means that the company has medium high variable costs. Further research needs to be done to determine the composition of the operating expenses and if all are necessary.

5. 5

Calculate the Net Profit Margin. The company's sales and net income are required. Net income is income after all production costs and expenses have been deducted. The formula to calculate net profit margin is Net Profit Margin = Net Income / Sales. Our example uses sales of £2,600,000 and net income of £390,000, resulting in Net Profit Margin = 600,000 / 4,000,000 = 15%.

6. 6

Analyse the Net Profit Margin. This figure, often referred to as the bottom line, reveals a company's profits after it pays all of its costs and expenses, including the cost of goods sold, administrative costs, selling costs, interest and taxes. Investors want consistently high net profit margins, so that a slight drop in sales will not incur a net loss (see Resources below). Our example company has a net profit margin of 15 per cent, which is not bad, but it can do better. The variable costs, as seen in the operating profit margin, are the concern because these are variable costs, which the company has more control over.

Tips and warnings

• Compare the profit margins with that of other companies in the same field to see if the company you are reviewing at least matches the industry average trends.
• Fixed costs are mostly external costs out of the company's control. Variable costs are mostly internal costs directly under the company's control.

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