Profit margin
A company's profit margin shows you what proportion of revenue that a company generates in sales it gets to keep as earnings.
It is calculated by dividing its net income by its sales revenue and multiplying it by 100. It is expressed as a percentage:
Profit margin = (net income/sales revenue) x 100
For example, a company with a net income or profit of £10 million and sales revenue of £100 million would have a profit margin of 10%. This means that for every £1 it generates in sales, it produces 10 pence in net profit.
A steadily rising profit margin is the best indicator of financial health – it suggests that a company is making constant progress at controlling its costs.
Profit margin is more useful than overall profit changes
Profit margin is a more useful measure of a company's financial health than any fall or rise in its overall profit.
This is because it shows you how effectively a company is managing its costs.
A profit margin of 10% or over generally indicates that a company offers you good investment potential.
However, average profit margins rise and fall with economic cycles and are different from industry to industry.
Therefore, profit margin is best used to compare companies in the same sector.
Again, look closely at a company's profit margin history. Even if a company's profit margin is fairly low, if it is consistent this indicates that the company is resilient. This can support its share price.
In contrast, a company whose profit margin is high in its latest financial statement but has been volatile from year to year or quarter to quarter could be at higher risk of bankruptcy.
A steadily rising profit margin is the best indicator of financial health. It suggests that a company is making constant progress at controlling its costs. This can push up demand for its shares, raising their price.
A profit margin of 10% or over generally indicates that a company offers you good investment potential. This differs from industry to industry and also depends on the current economic cycle.
Summary
So far you have learned that...
- … profit margin shows you what proportion of revenue that a company generates in sales it gets to keep as earnings.
- … a steadily rising profit margin is the best indicator of financial health – it suggests a company is making constant progress at controlling its costs.
- ... profit margin is best used to compare companies in the same sector.
