We recently explored net income, aka the “bottom line,” as one way to measure your company’s profitability. How else can you assess profitability? One way is by looking at profit margin, which can be defined as the ratio of profits earned to total sales or costs over a certain period of time.
Profit margin is a ratio of profitability, and can be expressed with this simple formula: Profit Margin = Net Profits / Sales. (As we saw in our previous post, What is an Accounting Transaction, profit is the money left over after you subtract your expenses from your income.)
You can think of profit margin as how much your company actually makes in earnings off of every dollar of sales. It’s a standard way to assess the flow of profits your business is bringing in over a set period of time compared with your sales and costs during the same period.
A quick example that puts to use the equation we saw above will help us to grasp this concept a little better…
Let’s say your company made $10 million in sales this year. (We’ll use nice big round numbers for illustrative purposes knowing full well that $10 million in sales is pretty spectacular.) After you’ve deducted all of your expenses (i.e., cost of goods sold, rent, salaries, interest payments, etc.), you end up with net profits of $1 million. To get your profit margin, all you have to do is divide net profits by sales: $1 million net profits / $10 million sales = 0.10, or 10% as profit margins are normally expressed as a percentage.
Now, let’s say that next year, your company manages to pull in $20 million in sales, with net profits of $1.5 million. By dividing net profits by sales, we get a profit margin of 7.5%. Even though both your net profits and sales have gone up in comparison with last year, your profit margin has actually decreased.
So what does this mean in terms of your company’s performance?
Profit Margin and Efficiency
In the example above, we saw that company profits and sales both increased from one year to the next, and yet by plugging these numbers into our equation, we found out that profit margin had actually decreased. Simply put, this means that the company has ended up making less money on every dollar of sales.
How can that be? A lower profit margin might mean that the company’s expenses are not being managed as tightly as they could be. (For more on expenses, be sure to check out our recent blog post, What is an Expense in Accounting?)
A growth in sales isn’t as meaningful unless expenses are kept under control, and cut wherever necessary. So, if your company is being run efficiently, with income and expenses tracked carefully using the right accounting software, you’ll be able to boost your efficiency and your profit margin—and that’s great news!
Who Looks at Profit Margin?
Getting an accurate reading on how efficiently your business is being run over a particular period of time isn’t for internal use only. Investors and creditors also look at your profit margins to gauge your company’s financial health, and compare it to other companies in the same market.
If your profit margins are high, your business is more likely to be seen as a good investment, and your stock prices will rise. And creditors want to be sure that you’ll be able to pay back what you’ve borrowed from them, so they will be interested in your profit margins as well.
Of course, profit margins can and do vary from business to business and industry to industry, but it is still a vital way to see how your company is performing compared with your competitors. It’s also another tool in your accounting toolbox to measure whether or not you’re running things efficiently and to identify areas ripe for improvement.
We hope this brief overview helped you to understand profit margin a little better, and why it is important when it comes to growing your business. Questions for us? Drop us a line any time at firstname.lastname@example.org!