Net income is critical when calculating the return on investment to the owners of a business. It is also referred to as the bottom line, or what the business owner gets to keep after all of his expenses are paid. Business analysts use comparisons and ratios to help them analyze the strength and performance of a business. The profit margin is one of these ratios.
The net income, or net loss of a business is listed towards the end of the income statement for the accounting period. It is the total of all revenues from the business, less all of the expenses associated with earning that revenue. Revenues come from sales of goods and services, but also from interest income and capital gains as well. Expenses include the cost of goods sold, as well as any payroll expenses or rent that the business incurs.
The profit margin is the ratio of total sales to income earned, expressed as a percentage. To calculate the profit margin, divide the net income for the business by the total amount of sales, and multiply by 100 to arrive at a percentage. For example, if a business had total gross sales of $100,000 for the accounting period, and reported a net profit of $10,000, the business had a 10 percent net profit margin.
Gross Profit Margin
Many businesses rely on the gross profit margin when analyzing business operations as well as net profit margin. Gross profit is the amount of money resulting from the sales of product, less the cost of goods sold. The cost of goods includes the invoiced price of the product for a wholesale or retail business, and includes all costs associated directly with the creation of the product in a manufacturing business. Divide the amount of gross profit by the total amount of sales, and multiply by 100 to calculate the gross profit margin as a percentage.
Importance Of Profit Margin
A high profit margin for a business when compared to competitors in the same type of wholesale or retail business can mean that the organization is able to operate with fewer expenses. This may be due to strategic buying, or it may be able to sell its product for more money. It may also have lower overall expenses due to good business management. If a business has a significantly different profit margin than its peers, careful review of the business operations is necessary to determine the root cause of this. Profit margin allows businesses to compare themselves with their peers, regardless of the amount of money that the business earns.