Profit Margin (PM)
Definition of 'Profit Margin (PM)'
An accounting term often used to refer to the net margin, profit margin (PM) is a profitability ratio used to represent overall earnings as expressed in a percentage. Before calculating the profit margin, the business’s net income is determined through subtracting the company’s operating costs (including overhead, salaries, taxes, materials). The true net income is then divided by revenue to arrive at the profit margin percentage.
TheStreet Explains ‘Profit Margin (PM)’
The profit margin can act as a company’s “report card” of profitability and growth. Companies use this accounting metric to identify areas of strength and weakness on a routine basis. Calculate the profit margin by PM=net income/net sales in order to arrive at a percentage.
Although the profit margin may not provide an in-depth analysis of a company’s health, it does measure a variety of important metrics such as expenses, overhead, pricing, economic conditions and market share. During an economic downturn or decline in product/service, interest profit margins may be low. Also, if a company’s expenses and overhead are high, especially in the case of a start up company that is merchandise-heavy, the profit margin may also be low. Another red flag factor companies should examine is pricing in the case of a low profit margin--sometimes goods are being priced too low, especially if volume is steady or even increasing.
For instance, if Joe’s Running Shoe company revenue is $1 million and expenditures are $800,000, Joe’s profit margin is 20%. Joe decides to examine expenditures and identifies several areas he can cut and revise, bringing his expenditures down to only $500,000 the following year. Provided his revenue remains at $1 million, his PM the following year is 50%. The tricky part for business owners is when cutting expenses to improve the profit margin, they don’t compromise or reduce a line item that is helping to raise revenue.
Investors will often use a company’s profit margin to determine whether a company is worth making an investment. Making an informed decision means comparing companies from identical industries with similar business models and sizes. Comparing a service-based company with no tangible product to a manufacturer would not elicit an accurate profit margin comparison or provide insight for investment. Also, knowing there are different types of profit margins is important for an accurate comparison. These include gross profit margin, operating profit margin, pretax profit margin and net profit margin.
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