Profit margin ratio, also known as net profit margin, is a financial ratio measuring the percentage of net income in net sales of a company. This metric is mostly used to compare different companies in the same industry.
The formula for profit margin ratio is expressed as follows:
|Profit Margin =||Net Income||× 100%|
Please note that profit margin is usually calculated for common shareholders. Thus, net income net of preferred dividends should be used.
Net income and preferred dividends (if available) can be found in the income statement and notes to the financial statements.
If comparing companies operating in various jurisdictions with different tax policies is needed, earnings before taxes should be used instead of net income to avoid the impact of taxation.
|Profit Margin =||Earnings before Taxes||× 100%|
The reported statement of income of XYZ company for the 20X8 financial year is as follows:
XYZ company has declared total preferred dividends of $250,000.
To find net income attributable to common shareholders, the total amount of preferred dividends of $250,000 needs to be excluded.
|Profit Margin 20X8 =||$5,350,000 - $250,000||× 100%||= 11.16%|
Tracking the change of profit margin ratio over time is also an important aspect of the financial analysis. Let’s suppose that in the prior year it was 9.53%. The current value of 11.16% compared with a baseline of 9.53% indicates that each dollar of sales contributes more to the company’s net income than in the prior year.
Profit margin is an important ratio for both investors and creditors as far as it measures how effectively management converts proceeds from sales to net income. From investors’ point of view, it helps to evaluate how effectively the company will manage distribution of dividends. In turn, creditors want to be sure that the profitability of a company is enough to meet its debt obligations.
Generally, higher values of profit margin are preferable, but it should be noted that some industries have higher margins, while others have very narrow margins. Thus, this ratio is best if it is necessary to compare companies of the same size operating in the same industry.
Let’s consider the example above and assume the industry average in the 20X8 financial year is 8.22%.
A profit margin ratio of 11.16% compared with the industry baseline of 8.2% indicates that management is effective in converting sales in net income.
You can also calculate the profit margin ratio using our online calculator.