Formula Of Profit Margin Ratio – As part of profitability analysis, net profit margin or net margin (also called margin after tax or PAT margin) is the most important ratio to look at. Net profit gives a more conclusive picture of a company’s profitability.
It tells us how profitable the company was after taking into account all types of expenses (direct expenses, indirect expenses, taxes, etc.).
Formula Of Profit Margin Ratio
No matter how profitable the company is at the gross profit margin level, if your after-tax profit is too low, there isn’t much left for shareholders. Therefore, it is important to analyze PAT and PAT margin.
How To Convert Markup Into Margin (or Margin Into Markup)
Before understanding the meaning of net profit margin, it is important to understand the meaning of net profit.
Companies sell goods or services and generate revenue. However, revenue is earned only if expenses are incurred. Net profit or profit after tax (PAT) is nothing but the final profit earned by the company after covering all its expenses. Therefore, net profit simply shows how much profit is left at the end after covering all the company’s expenses.
Now, that we have understood the meaning of net profit, we are in a good position to understand the meaning of net margin or PAT margin.
Net margin means how much net profit the company is making on each dollar of sales. Therefore, it tries to create a relationship with profit and sales. If the ratio is high, it means the company is making a good profit on each dollar of sales.
Understanding The Operating Profit Formula & How To Calculate It
Now, let us turn our attention to the formula and try to understand how to calculate the ratio.
Net profit can be taken from the income statement of the company. It is reported below just before earnings per share
Although finding net sales is easy enough, we need to understand how net profit is calculated. Refer to the figure below to understand how net profit is arrived at after deducting various expenses from revenue.
Net Profit = Revenue – COGS – Other Expenses – Depreciation and Amortization – Interest Expense – Taxes
Markup Vs Gross Profit Percentage
Now that we know how to arrive at net profit and sales, let’s look at an example to calculate the ratio practically.
The net profit for both the companies can be obtained from the above income statement. We need to deduct all expenses like cost of sale, other expenses, D&A, interest expenses, income tax.
What this means is that Alpha Inc was more efficient in managing its costs so that it could generate a higher net profit on each dollar of sales.
In the case of Beta Inc, the company could not keep its expenses under control as a result, it ended up with a net profit margin of only 12%.
Profit Margin (%)
One can compare the expenses of the two companies and see that in the case of Beta Inc, the cost of sales was about 50% of its revenue. Whereas for Alpha Inc it was only 25%. So, obviously because of this reason, Alpha Inc managed to earn high net profit margin
To know the net profit we need to look at the bottom of the income statement. As highlighted in the figure above, the company’s net profit for the year ending January 31, 2020 is $15,201. This amount is arrived at after deducting all kinds of expenses incurred by the company as part of its operations. (Cost of sales, depreciation, interest expense, income tax etc.)
Net sales can be easily obtained from the income statement. It has been informed at the beginning. The company’s revenue for the year ending January 31, 2020 is $523,964.
As is clearly evident, Walmart has a low single-digit net profit margin of 2.9%. What this shows is that for every $100 in revenue, the company has only $2.9 left. Historically, the company has been earning low single-digit net margins.
What Is Gross Profit Margin
It cannot be concluded that the company is not performing well on the mere fact that the net margin of the company is low. We need to look at other players in the same sector to understand whether such low profitability ratios are industry-specific or company-specific.
Not all companies enjoy pricing power or competitive advantage. In such a situation, the company should resort to cost control to improve the net margin. This can be achieved at different levels like gross profit margin level, EBITDA margin level, operating profit margin level, etc.
One of the best examples on Wall Street is how the social media giant, Facebook, manages to translate its high gross profit margins into net profit margins.
In the figure below, we have shown Gross Profit Margin, EBITDA Margin, Operating Profit Margin, Pretax Profit Margin and finally Net Margin.
Loss And Percentage Profit Calculation Formulas
It is worth noting that a company like Facebook is the market leader in the social media advertising industry. Due to low competition, the company earns gross profit margins in the range of 80% to 90%. While other companies can earn such a high GP margin ratio, not all companies can translate this to the bottom line.
In the case of Facebook, the GP margin in 2015 was 84%. But, as we go down in the income statement, the company was left with only 24% PAT margin. Since the company didn’t have incremental costs as it scaled, Facebook was able to increase its operating margin which resulted in increased PAT margin.
In analyzing any financial ratio, apart from looking at the company level, we also need to see how the ratio is for other similar companies.
In the following series of diagrams, we try to compare the net margin profile for different companies in different industries.
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We see that the margin profile for Walmart is in the low single-digits. However, this is a company-specific issue as other companies such as Home Depot report relatively higher net profit margins.
As part of explaining the formula with an example, we calculated the PAT margin for Walmart. The proportion was as low as 2%.
But, compared to 2018, the margin increased during 2019. Barring this increase, the ratio has been in the range of 1%-4%.
Unlike Walmart, the margin profile for Home Deport is relatively better. The company’s margin is in the range of 8%-10%. This is mainly possible due to relatively high gross profit margin compared to Wal-Mart.
Gross Profit Vs. Net Income: What’s The Difference?
The company not only has high margins, but is also able to increase it over time. Margins increased from 8% during 2015 to 10% in 2019.
US electronic gadgets maker Apple makes net profit margins in the range of 20%-23%. The margin profile has been fairly stable, if not increased, over the last few years. Although the company has high pricing power, the company is unable to increase its gross profit margin or operating margin to increase its net margin.
Nevertheless, the company has built a vast ecosystem for its users, gradually, in the coming days, the company expects to increase its margins by increasing prices (offering best in class and diversified products/services). .
Another technological advantage, Google also earns a net profit margin in the range of 20%-23%. Although the company earns high gross margins in the range of 55% to 60%, the company also incurs high expenses leading to net margins in the 20% range.
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Since the company has a sea of products/services, improving margins with the right business mix is a difficult task. If the company focuses on controlling costs or raising prices in areas like advertising and cloud, we may see a margin improvement in the coming days.
The margin profile for Microsoft has been quite volatile over the past few years. During 2015-16, the company was able to increase its EBITDA margin from around 26% to 36%. Because of this, the net profit margin also jumped from 13% to 23%. Since then the company has been strategically focusing on improving margins.
For the year ended June 30, 2020, Microsoft’s net profit margin was 31% compared to 15% for the year ended June 30, 2018.
It is interesting to note that the US-based oil company earns a net profit margin in the range of 5% to 9%. The margin profile has been quite volatile over the past few years.
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As the world moves towards a digital ecosystem, most transactions are expected to be done online. In this case, global payment system companies like Paypal are always expected to benefit. The company’s efforts to increase margins are not bearing fruit yet. The ratio is stable in the range of 13% to 15%.
Johnson & Johnson, a US-based pharmaceutical, consumer goods, medical device maker earns net margins in the 18% to 20% range. Although the company makes around 70% GP margin, when it comes to the bottom line, the company is left with only 20% net profit. Since, the company has diverse business verticals, increasing margins with an optimal business mix will always be a challenge.
It is truly amazing how US-based electric automobile company TESLA was able to cut its losses. As evident in the figure above, the company was making significant losses with a negative net margin in the range of -9%.
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