What is a profit margin?
It's the percentage of a company's earnings left after all costs and expenses have been deducted. Rather than looking individually at revenue or expenditure, it shows what ratio of a company's sales actually translate into profit, so it's a useful measure of how a company is performing.
Where have you heard about profit margins?
Everywhere; it's one of the most commonly analysed measures in business and investing.
A business may look at their profit margin to see how they're performing over time and how any changes they make – like adding a new product line or decreasing staff numbers – influence their profitability. They can also use it to check they're not over or under-pricing their goods or services, and to evaluate their performance against other businesses.
It's a useful indicator if you want to evaluate a potential investment's performance within a particular industry.
What you need to know about profit margins.
There are a few different types of profit margins – for example a pre-tax profit margin shows a company's profitability before tax has been deducted – but it's most commonly used to refer to the net profit margin.
To calculate the net profit margin subtract the total expenses – including all costs, taxes, and other revenues like depreciation and interest from the total sales for a given period. Then divide this figure by the total sales to get the profit margin, expressed as a percentage:
Net profit margin = (total revenue - total expenses) / total sales
So, if a company has total annual sales of $500,000 and total annual costs of $200,000 its net profit margin would be 0.6 or 60%.
Find out more about profit margins.
There are other measures of profitability like pretax profit margins and operating profit margins.