Profit Margin Definition

Let us look at the example of Etsy above. First, we note that the company’s gross margin is around 64.5%. However, its operating margin and profit margins are negative at -0.69% and -19.8%. Why is this so?

However, before we answer “Why,” it is important to understand the meaning of three types – gross margin, operating margins, and net profit margins!

Let us discuss each one of them in detail:-

#1 – Gross Profit Margin

It is also known as gross margin or gross profit ratio. It is calculated as per below: –

Gross Profit Margin Formula = (Sales – the Cost of Goods Sold)/Sales or Gross Profit/Sales

  • The ratio measures the gross profit ratio on the total sales made by the company.The gross profit represents the excess of sales proceeds during the period under observation over their cost before taking into account administration, selling and distribution, and financing chargesFinancing ChargesThe finance charge, also known as the cost of borrowing or cost of credit, is the accrued interest or fees that have been charged on the approved credit facility. Usually, this charge is a flat fee, but most of the time it is a percentage of the amount borrowed on an extended line of credit.read more. The ratio measures the efficiency of the company’s operations, and one can also compare this with the previous years’ results to ascertain the efficiency.When everything is normal, the gross margin of profit should remain unchanged, irrespective of the level of production and sales. That is so because it stands on the hypothesis that while computing gross profit ratioGross Profit RatioThe gross profit ratio evaluates the proportion of the direct profit a company generates from its net sales. Here, the gross profit is the returns acquired after considering the cost of goods sold, trade discounts and sales returns for deduction from the total revenue.read more, all expenditures are to be subtracted, which are directly volatile with sales.

source: ycharts

One might compare the margin of gross profit with that of competitors in the industry to assess the operational accomplishment of other industry players.

#2 – Operating Profit Margin

It is also known as operating margin or operating profit ratio, or EBIT margin (Earnings before interest and taxes).

The operating margin is calculated as follows:

Operating Profit Ratio Formula = Operating profit/Sales or EBIT/Sales

Or (Net profit as per profit and loss accountPer Profit And Loss AccountThe Profit & Loss account, also known as the Income statement, is a financial statement that summarizes an organization’s revenue and costs incurred during the financial period and is indicative of the company’s financial performance by showing whether the company made a profit or incurred losses during that period.read more + non-operating expenses – non-operating incomes) * / Sales.

  • This ratio estimates the effectiveness of the operations of the company.The ratio concentrates on the profit margin of business activities before tax deduction and interest.This ratio reflects the operating margin on profit on the total sales after deducting all expenses, excluding tax and interest.

source: Etsy SEC Filings

Please note that operating income can be considered the “bottom line” from operations.

#3 – Net Profit Margin

It is also known as net margin or ratio on net profit. The net margin is computed below: –

Net Margin Formula = Profit After Tax (PAT)/Sales or Net profit/Sales

  • This ratio reflects the net margin on profit on the total sales after deducting all expenses covering interest and taxation.One important point that we should note here is that net margin can increase or decrease due to non-recurring itemsNon-recurring ItemsNon-recurring items are income statement entries that are unusual and unexpected during regular business operations; examples include profits or losses from sale of asset, impairment costs, restructuring costs, and losses in lawsuits, and inventory write-off.read more.Therefore, it is important to consider those before we conclude.

Examples

Example 1

ABC Ltd. has made plans for the next year. It is estimated that the company will employ total assets of $80,000, 50% of which will be financed by borrowed capital at an interest rate of 16% per year. The direct costs for the year are estimated at $48,000, and all other operating expenses are estimated at $8,000. They will sell the goods to customers at 150% of the direct costs. The income tax rate is assumed to be 50%.

You are required to calculate the following: –

(a) Gross margin,

(b) Net margin

(c) EBIT Margin.

Calculation of sales

Sales = 150 % of direct costDirect CostDirect cost refers to the cost of operating core business activity—production costs, raw material cost, and wages paid to factory staff. Such costs can be determined by identifying the expenditure on cost objects.read more = $ 48,000 * 150 / 100 = $ 72,000

Calculation of Profits

Calculation of Gross Margin

Gross Margin = Gross Profit * 100 / Sales = 24,000 * 100 / 72,000 = 100 / 3 = 33.33 %

Calculation of Net Margin

Net margin = Profit after-tax or net profit * 100 / Sales = 4,800 * 100 / 72,000 = 20 / 3 = 6.7 %

Calculation of EBIT Margin

EBIT Margin = Operating profit or EBIT * 100 / Sales = 16,000 * 100 / 72,000 = 100 / 6 = 16.67 %

Example 2

Z Ltd. has the following information:-

You are required to interpret and analyze the changes in profitability margin.

Technology Sector Example

Below are the top 20 companies in the technology sector with a Market CapitalizationMarket CapitalizationMarket capitalization is the market value of a company’s outstanding shares. It is computed as the product of the total number of outstanding shares and the price of each share.read more of more than $25 billion.

  • The average gross margin for this peer group is around 46.8%, the average operating margin is 17.8%, and the net margin is 15.3%.Facebook and Adobe have the highest gross margin in this peer group since they do not sell tangible products (no raw material as they are into software/internet where direct costs are less).Though Apple has a gross margin, which is way low than Facebook, they have a higher direct cost (including the manufacturing, raw material, and direct labor costs). However, Apple does well at the operating level (~27.8%) and profit margin levels (21.2%).Salesforce.com is the only company in the peer group with a negative profit margin (~0.7%). It is even though it has an exceptionally high gross margin.Salesforce.com’s marketing and sales costs are around 50% of the total revenue. With this unusually high marketing expense, the company’s profitability margin suffers and is negative.

source: Salesforce SEC Filings

Utilities Sector Example

Below are the top 12 companies with more than $25 billion in the utility sector market capitalization.

  • The average gross margin for this utility peer group is around 51.9%, the average EBIT margin is 19.0%, and the net margin is 10.6%.We note that the highest gross margins for the utility sector are less than that of the technology sector. It is expected primarily due to higher direct costs (manufacturing, raw material, transmission, etc.) associated with the utility sector.Engiy (ticker – ENGIY) is the only company that has a negative EBIT margin (~4.6%) and a negative net margin (~6.6%).American Electric, Dominion Resources, and Duke Energy have a robust Gross Profit MarginGross Profit MarginGross Profit Margin is the ratio that calculates the profitability of the company after deducting the direct cost of goods sold from the revenue and is expressed as a percentage of sales. It doesn’t include any other expenses into account except the cost of goods sold.read more (>60%), EBIT margins (>20%), and net margins (>12%).
  • EBIT MarginPrice to Book Value RatioCurrent Ratio MeaningDefinition of Working Capital Ratio