In order to measure the amount of net income earned by a company with each dollar sales that are generated we use the profit margin ratio. Also known as gross profit ratio or the return of sales ratio, this is determined by comparing the net income with the net sales of a certain company. Basically, the profit margin ratio helps us see the percentage of sales left after all of the company’s expenses are paid.
This ratio is commonly used by investors and creditors in order to determine how effective a company is when it comes to converting its sales into net income. Naturally, creditors want to see if the company is making enough profit and is, therefore, able to pay back its loans.
On the other hand, investors want to see if the company’s profits are high enough in order to distribute dividends. A low-profit margin ratio shows that a company’s expenses are high – or too high – and that the management team would better budget and cut the expenses.
What You Need to Know about the Profit Margin Ratio
In short, this ratio is used to see the percentage of sales that comes from the net income of a company – show how much profit is being made when given a certain level of sales.
Moreover, the ratio is helpful in determining if a company’s budget is used wisely – this is done by comparing its expenses to the net sales.
This profitability ratio can be used in two ways – one, to make a comparison between two companies that activate in the same industry and two, to measure the past performance of a certain company.
The Formula of the Profit Margin Ratio
The formula used to determine the profit margin ratio is very simple and intuitive. All one has to do is divide the net income by the net sales of their company of choice. The net sales variable is calculated by subtracting the refunds and the returns from the gross sales of the company. The net income is calculated by subtracting the total expenses from the total revenues.
The latter can be usually found on the income statement of the company, as the last number that is reported.
As we previously mentioned, this ratio shows if a company is managing is expenses in an efficient way or not – that’s why higher profit margin ratios are desired within a company.
A higher profit margin ratio is usually achieved by generating more revenue, but while keeping the expenses on the same level – on the other hand, one company might also try to keep their revenues on the same level, while trying to lower their expenses.
Naturally, generating more revenue is usually the hard thing to do. Therefore, as we all know, the management teams of many companies out there are usually trying to cut their spending budget first so that they improve the profit ratio of the company.
Overall, it depends on the company’s abilities and on the decisions of the management team – sometimes it might be better to try and increase profit/ revenue than cutting down the budget.