how profit margin works
businesses and individuals around the globe perform economic activities with the aim of making a profit numbers like x million in gross sales or y million in earnings are useful but don t address a business s profitability and comparative performance several different quantitative measures are used to compute the gains or losses that a business generates which makes it easier to assess the performance of a business over different time periods or compare it against competitors profitability ratios are often the first thing investors look at before investing in a company and the most popular and widely watched of them all are profit margins while privately owned businesses like local shops may compute profit margins at their own desired frequency like weekly or monthly publicly traded companies are required to report them in accordance with the standard reporting time frames typically quarterly and or annually businesses that are running on borrowed money may be required to compute and report their profit margins to lenders like a bank monthly 1there are other key profitability ratios that analysts and investors often use to determine the financial health of a company they include return on assets roa and return on equity roe types of profit marginwhile net profit margin is the most familiar and commonly used measure there are actually four levels or types of profit margin based on four kinds of profit these profits are reflected on a company s income statement in the following sequence here are the mathematical formulas for calculating three types of profit margin gross profit margin operating profit margin and net profit margin uses of profit margin in business and investingfrom a billion dollar corporation to an average joe s sidewalk hot dog stand profit margin is widely used by businesses around the globe it is also used to indicate the profitability potential of larger sectors and of overall national or regional markets it is common to see headlines like abc research warns on declining profit margins of american auto sector or european corporate profit margins are breaking out in essence the profit margin has become the globally adopted standard measure of the profit generating capacity of a business and is considered a top level indicator of its potential it is one of the first few key figures to be quoted in the quarterly results reports that companies issue business owners company management and external consultants use it internally for addressing operational issues and to study seasonal patterns and corporate performance during different time frames a zero or negative profit margin translates to a business that s either struggling to manage its expenses or failing to achieve good sales drilling it down further helps to identify the leaking areas like high unsold inventory excess or underutilized employees and resources or high rentals and then to devise appropriate action plans profit margins serve many purposes among other things they help companies to identify issues raise funds and attract investors enterprises operating multiple business divisions product lines stores or facilities that are spread out geographically may use profit margins to assess the performance of each unit and compare them against one another profit margin often comes into play when a company seeks funding smaller businesses like a local retail store may need to provide it to get or restructure a loan from banks or other lenders large corporations issuing debt to raise money are required to reveal their intended use of the capital which can provide insights to investors about the profit margin that might be achieved either by cost cutting increasing sales or a combination of the two the number has become an integral part of equity valuations in the primary market for initial public offerings ipos finally profit margins are a significant consideration for investors when comparing two or more companies investors often hone in on their respective profit margins if a company has a higher profit margin than its peer group it suggests it is better run and capable of generating greater returns for investors comparing profit marginsprofit margins are commonly used not just to compare a company s current performance against its past one but also to compare it to other companies this only really works though when looking at similar companies operating in the same sector what is an acceptable or good profit margin in one industry may be terrible or ridiculously high in another one businesses like retail and transportation will usually have high turnaround and revenue which can mean overall high profits but low profit margins high end luxury goods by comparison may have low sales volume but high profits per unit sold below is a comparison of the profit margins of four long running and successful companies in the technology and retail spaces from 2015 to the first quarter of 2024 technology companies like microsoft and alphabet registered high double digit quarterly profit margins compared to the single digit margins achieved by walmart and target however that does not mean walmart and target did not generate profits or were less successful at what they do compared to microsoft and alphabet they just run very different businesses since they belong to different sectors a blind comparison based solely on profit margins would be inappropriate profit margin comparisons between microsoft and alphabet and between walmart and target are more appropriate examples of high profit margin industriesproducers of luxury goods and high end accessories can have a high profit potential despite low sales volume compared with the makers of lower end goods a very costly item like a high end car may not even be manufactured until the customer has ordered it making it a low expense process for the maker without much operational overhead software or gaming companies may make a substantial investment initially in developing a new software product or video game but cash in big later by selling millions of copies with very little additional expense similarly patent secured businesses like pharmaceutical companies may incur high research costs initially but reap high profit margins when they bring a new drug to market according to nyu stern school of business the companies in the u s with the highest profit margins as of jan 2024 are banks oil and gas producers and explorers and tobacco companies 2