Definition: Profit margin, also called return on sales, is a financial ratio that measures the profit percentage that each sales dollar generates by comparing net income to net sales. In other words, this ratio calculates the amount of net income that will be generated from one dollar of sales revenue.
What Does Profit Margin Mean?
The profit margin ratio formula is calculated by dividing net income by net sales. Investors, creditors, and internal management use this calculation to analyze how efficient the business is at producing profits. The results are often looked at from two different perspectives. Analyzers can focus on revenues or expenses. For instance, increasing total revenues can create a more favorable figure. On the other hand, decreasing expenses can accomplish the same favorable figures. That’s why this is a good calculation of efficiency and profitability. It shows how well the company utilized its resources (expenses) to generate sales.
Since the ratio is stated as a percentage, small and large companies across all industries can be compared.
Let’s took at an example.
Jeff’s Brewery is a local pub that is currently looking for new investors. Last year Jeff had net sales of $150,000 and total expenses of 125,000. Thus, his margin was 16% (25,000 / 150,000). This means that for every $100 of sales, Jeff only earned $16 of profit after the expenses were paid. This was one of Jeff’s worst performing years in the last decade, so this year he decided to make some changes.
He first decided to establish controls over purchases and set spending limits on managers. He also decided to start advertising and trying to attract new people to his brewery by holding microbrew workshops. At the end of the year, Jeff increased his net sales to $225,000 while increasing his expenses to $155,000. Jeff’s current profit margin ratio is 31% ($70,000 / $225,000). By controlling expenses and increasing sales, Jeff was able to almost double his margin.