When you’re a busy entrepreneur it can be easy to get lost in figures like expenses, sales, and earnings. However, these numbers don’t paint the whole picture of your company’s health. That’s why it’s important to understand your company’s profit margins, which show you the proportion of how much profit you’re actually earning when compared to your expenses. Luckily, profit margins are easy to calculate and understand. Here’s a brief overview of what every entrepreneur should know about these critical ratios:
Understanding your profit margin
A profit margin is a type of profitability ratio. It represents how much net income you gain for every dollar of sales your business makes. This figure is always represented as a percentage. For example, if your company’s profit margin is 25 percent, it means you’ve earned $0.25 in net income from every dollar you’ve obtained. To find your company’s profit margin for a given period, such as a month or a quarter, subtract your expenses from your sales. Then, divide that figure by your revenue, and multiply the result by 100. A higher profit margin indicates greater profitability. Although there are different profit margins —gross, operating, and net — each follows this pattern and can lend insight into the strengths and weaknesses of your company.
Discovering your gross profit margins
A gross profit margin gives a quick and easy way to compare your company’s sales to the amount of money it takes to produce your products. These expenses include what you pay for employee labor and the cost of the goods used to create each unit of product. According to Kimberly Amadeo, a contributor to The Balance, you’ll have to use a different figure if your company deals in services rather than goods. Amadeo recommends computing your gross profit margin with the business’s cost of revenue.
Getting a grip on operating profit margins
Operating profit margins are similar to gross profit margins, but also account for expenses like rent, office supplies, insurance, utilities and the cost of paying your employees’ benefits. However, this figure does not include taxes and interest on loans. While the operating profit margin doesn’t provide a full picture of your business, it is often useful to anyone who’s assessing a business during a buyout.
Knowing your net profit margin
Your net profit margin is the most relevant and commonly used form of profit margin, according to Investopedia. This helpful figure contrasts your net profit with your total revenue. To find your net profit, just subtract all expenses, including overhead, interest and taxes from your total revenue. However, Amadeo warns that net profit margins aren’t appropriate for comparing companies in different sectors, because each industry has its own financial conventions and practices.
Your profit margin will vary based on the nature of your business. For instance, Investopedia explains that agricultural operations and transportation companies tend to have a low profit margin due to fluctuating prices and uncertain factors, like equipment breakdowns. However, understanding your company’s profit margin can help you find places where you can cut expenses and build upon your successes. If you’d like help calculating your company’s profit margin, consult your finance department or a financial advisor.