So much of financial analysis -- for business owners, managers and investors alike -- boils down to ratios. Examining the relationships between specific items in a company's financial statements can provide key insights on profitability, productivity and efficiency. One of the most basic ratios addresses the relationship between a company's sales and its earnings -- but neither "sales" nor "earnings" appears in the name. Rather, it's called profit margin.
Your company is in business to sell something. If you own a grocery store, you sell groceries and similar items. If you own a flooring company, you sell and install carpet, tile, hardwood and other materials. If you run a consulting business, you sell advice. If you're an editor or interior designer, you sell expertise. Whatever your core business is, the money you earn from doing it is your sales, also called revenue. Many businesses are able to pull in money from sources outside their core operations -- by selling assets, for example, or renting out their excess warehouse space -- but such income doesn't get included in sales revenue.
"Earnings" is just another word for profit. It's what's left over after your company adds up all its sales, plus any other income, and subtracts all its costs. Those costs include not only your direct business costs -- wages, rent, the cost of goods sold -- but also taxes, interest, non-cash expenses such as depreciation, and losses such as damaged inventory that has to be written off and assets sold for less than book value. Earnings also goes by the name net income. "Bottom line," a business term that has long since crept into everyday language, refers to net income, which appears at the bottom of an income statement.
Take your company's net income (earnings) and divide it by revenue (sales). The result is your company's profit margin. This figure tells you what percentage of sales eventually comes out as profit. For example, a business with $450,000 in revenue and net income of $70,000 has a profit margin of $70,000 divided by $450,000, or about 15.6 percent. You can also turn the ratio over and divide revenue (sales) by net income (earnings). This calculation tells you how much revenue the company had to earn to produce $1 in profit. In the example, it's $450,000 divided by $70,000 -- or about $6.43. Since it uses the same inputs as profit margin, this tells you the same thing, just in a different way.
In the preceding example, you might wonder whether a 15.6 percent profit margin is good or bad. The answer is that it depends on the industry in which a company operates. Some businesses have thin profit margins, but make up for them with high volume. A 2 percent margin on $100,000 in sales, for example, is only $2,000 -- but on $10 million in sales, it's $200,000. Others have high margins but low volume, and some are able to pull of high margins and high volume. The key to interpreting a particular company's margin is to compare it to the average margin in its industry as well as to the margins of its major competitors.
- "Financial Accounting for MBAs," Fourth Edition; Peter Easton, et al
- Finance Formulas: Net Profit Margin
- Steve Mason/Photodisc/Getty Images