What is a Profit Margin?
A Profit Margin is a financial metric that measures the percentage of a company’s revenue that remains once certain expenses have been accounted for.
By comparing the profit metric to revenue, one can evaluate the profitability of a company after deducting certain types of expenses – which helps triangulate where a company’s expenses are concentrated (i.e. cost of goods sold, operating expenses, non-operating expenses).
- What is the definition of a profit margin?
- What are the common types of profit margins?
- For purposes of comparison, which profit margins are most useful?
- How does the industry influence profit margins?
Table of Contents
- How to Calculate a Profit Margin
- Profit Margin Formula
- Types of Profit Margins – Summary Chart
- How to Calculate Profit Margin Metrics
- Core Operating Line Items
- Non-Core Line Items
- EBITDA vs. EBIT Margin
- Profit Margin by Industry
- Salesforce – Software CRM Example
- Walmart – Retail Chain Example
- Profit Margin Calculator – Excel Template
- Profit Margin Example Calculation
How to Calculate a Profit Margin
A profit margin is defined as a ratio that divides a profitability metric by revenue.
There are various different types of profitability metrics that could be used, such as the following:
Profit Margin Formula
For practically all profit margins, the general “plug-in” formula is as follows.
Profit Margin Formula
- Profit Margin = (Profit Metric ÷ Revenue)
Typically, profit margins are denoted in percentage form, so the figure is then multiplied by 100.
Types of Profit Margins – Summary Chart
The chart below lists the most common profit margins used for assessing companies.
|Net Profit Margin||
How to Calculate Profit Margin Metrics
Core Operating Line Items
The operating margin (or EBIT) represents the line on the income statement that splits core, ongoing business operations from non-operational line items.
Financing activities like interest on debt obligations are categorized as a non-operating expense because decisions on how to finance a company are discretionary to management (i.e. the decision to fund using debt or equity).
For comparative purposes, EBIT and EBITDA are used most frequently due to how the company’s operational performance is portrayed – while remaining independent of capital structure and taxes.
Profit margins that are independent of discretionary decisions such as the capital structure and taxes (i.e. jurisdiction-dependent) are most useful for peer comparisons.
When it comes to company-to-company comparisons, isolating the core operations of each company is important – otherwise, the values would be skewed by non-core, discretionary items.
Non-Core Line Items
By contrast, profitability metrics that are below the operating income line (i.e. post-levered) have adjusted EBIT for non-operating income/(expenses), which are classified as discretionary and non-core to the company’s operations.
An example is the net profit margin, since non-operating income/(expenses), interest expense, and taxes are all factored into the metric.
Unlike the operating margin and EBITDA margin, the net profit margin is directly impacted by how the company is financed and the applicable tax rate.
EBITDA vs. EBIT Margin
For purposes of comparison among different comparable companies, the two most commonly used profit margins are:
- Operating Margin
- EBITDA Margin
The notable difference between the two is that EBITDA is a non-GAAP measure that adds back non-cash expenses (e.g. D&A).
In particular, depreciation and amortization represent non-cash accounting conventions used to match CapEx spend with the corresponding revenue generated under the matching principle.
Besides D&A, EBITDA can also be adjusted for stock-based compensation as well as other non-recurring charges. The adjustments are done to remove the effects of non-cash expenses and non-recurring, one-time items.
Profit Margin by Industry
Determining whether a company’s profit margin is “good” or “bad” depends on the industry in question.
Hence, comparisons among companies operating in different industries are not recommended and are likely to lead to misleading conclusions.
To provide some brief examples, software companies are well-known for exhibiting high gross margins, yet sales & marketing expenses often cut into their profitability significantly.
On the other hand, retail and wholesale stores have low gross margins due to most of their expenses being related to:
- Direct Labor
- Direct Material (i.e. Inventory)
For those looking for a more detailed breakdown of the gross margin, operating margin, EBITDA margin, and net margin metrics for different industries, NYU Professor Damodaran has a useful resource that tracks the various average profit margins by sector:
Salesforce – Software CRM Example
As a real-life example, we’ll look at the margin profile of Salesforce (NYSE: CRM), a cloud-based platform oriented around customer relationship management (CRM) and related applications.
In the fiscal year 2021, Salesforce had the following financials:
- Revenue: $21.3bn
- COGS: $5.4bn
- OpEx: $15.4bn
Given those data points, Salesforce’s gross profit is $15.8bn whereas its operating income (EBIT) is $455m.
Of the core operating costs – i.e. COGS + OpEx – the corresponding % of revenue amounts were:
- COGS % Revenue: 25.6%
- OpEx % Revenue: 72.3%
Furthermore, the gross and operating margins of Salesforce in 2021 were:
- Gross Margin: 74.4%
- Operating Margin: 2.1%
As mentioned earlier, Salesforce is an example of a software company with high gross margins but with substantial operating costs, especially for sales & marketing.
Salesforce Cost of Revenue and Operating Expenses (Source: 2021 10-K)
Walmart – Retail Chain Example
Next, we’ll look at Walmart (NYSE: WMT) as a retail industry example, which we’ll contrast against our prior software industry example.
For the fiscal year 2021, Walmart had the following financial data:
- Revenue: $559.2 bn
- COGS: $420.3 bn
- OpEx: $116.3bn
Therefore, Walmart’s gross profit is $138.8bn while its operating income (EBIT) is $22.5bn.
Just like we did for Salesforce, the operating cost breakdown (i.e. % of revenue) is as follows:
- COGS % Revenue: 75.2%
- OpEx % Revenue: 27.7%
Furthermore, the margins of Walmart were:
- Gross Margin: 24.8%
- Operating Margin: 4.0%
From our retail example, we can see how inventory and direct labor comprised the majority of Walmart’s total core expenses.
Walmart Cost of Sales and Operating Expenses (Source: 2021 10-K)
Profit Margin Calculator – Excel Template
We’ll now move to a modeling exercise, which you can access by filling out the form below.
Profit Margin Example Calculation
Suppose we have a company with the following last twelve months (LTM) financials.
- Revenue = $100 milion
- COGS = $40 million
- SG&A = $20 million
- D&A = $10 million
- Interest = $5 million
- Tax Rate = 20%
Using those assumptions, we can calculate the profit metrics that will be part of our margin calculations.
- Gross Profit = $100 million – $40 million = $60 million
- EBITDA = $60 million – $20 million = $40 million
- EBIT = $40 million – $10 million = $30 million
- Pre-Tax Income = $30 million – $5 million = $25 million
- Net Income = $25 million – ($25 million * 20%) = $20 million
If we divide each metric by revenue, we arrive at the following profit margins for our company’s LTM performance.
- Gross Profit Margin = $60 million / $100 million = 60%
- EBITDA Margin = $40 million / $100 million = 40%
- Operating Margin = $30 million / $100 million = 30%
- Net Profit Margin = $20 million / $100 million = 20%