Expressed as a percentage, it indicates how much profit the company makes for every dollar of revenue generated.
Profit margin is important because this percentage provides a comprehensive picture of the operating efficiency of a business or an industry.
All margin changes provide useful indicators for assessing growth potential, investment viability and the financial stability of a company relative to its competitors.
Maintaining a healthy profit margin will help to ensure the financial success of a business, which will improve its ability to obtain loans.
For example, if a company reports that it achieved a 35% profit margin during the last quarter, it means that it netted $0.35 from each dollar of sales generated.
[2] Profit margin is calculated with selling price (or revenue) taken as base times 100.
It is difficult to accurately compare the net profit ratio for different entities.
Profit margin is an indicator of a company's pricing strategies and how well it controls costs.
Gross profit is calculated by deducting the cost of goods sold (COGS)—that is, all the direct costs—from the revenue.
Net profit is calculated as revenue minus all expenses from total sales.
It is a standard measure to evaluate the potential and capacity of a business in generating profits.
These margins help business determine their pricing strategies for goods and services.
The pricing is influenced by the cost of their products and the expected profit margin.
[1] Profit margin is also used by businesses and companies to study the seasonal patterns and changes in the performance and further detect operational challenges.
For example, a negative or zero profit margin indicates that the sales of a business does not suffice or it is failing to manage its expenses.
This encourages business owners to identify the areas which inhibit growth such as inventory accumulation, under-utilized resources or high cost of production.
Profit margins are important whilst seeking credit and is often used as collateral.
They are important to investors who base their predictions on many factors, one of which is the profit margin.
To attract investors, a high profit margin is preferred while comparing with similar businesses.
Profit margins can be used to assess a company's financial performance over time.
Low profit margins can act as a warning to a company's owners and directors that the company might be in distress or the goods are being sold too cheap: "whatever the reason, low margins could signal trouble in the long run".
Margins can also be used to identify areas of a company's operations that may be inefficient or not cost effective.
In some cases, companies may agree to cover profit margin shortfalls as part of a business-to-business supply contract, such as an agreement between a retailer and a supplier.
However, in the UK, a Groceries Code Adjudicator report published in 2015 found that requirements to cover margin shortfalls imposed on suppliers by supermarket chains, where they had not been contractual agreed, were seen as a "relatively common" problem among suppliers.
[6] Estimated average after-tax unadjusted operating margin in the US by sector as of January 2024:[7]