Profitability is the ability of a business to generate profit from its revenue and is indicated in the financial projections template by the profit margin ratio. Additionally the ratio is an indicator of how well a business can control its expenses in relation to its revenue, and represents the percentage of revenue left after deducting all expenses. The ratio is sometimes referred to as the return on sales (ROS), or net profit margin ratio.
Profit Margin Ratio Formula
The profit margin ratio formula is the net income divided by the revenue of the business.
Profit margin ratio = Net income / Revenue
Both net income and revenue are from the income statement of the business. It is important to realize that the net income is usually the bottom line of the income statement and might be referred to as profit after tax. Additionally revenue is normally the top line on the income statement and might be referred to as sales or turnover.
The higher the profit margin ratio the more profit it earns from its revenue. A negative ratio indicates a loss making business.
Profit Margin Example
The income statement below is an example to show how to calculate the net margin ratio.
|Cost of sales||55,000|
|Income before tax||19,000|
|Income tax expense||4,600|
The numbers used in the calculation of the profit margin ratio are highlighted in the income statement shown. In the above example the revenue is 120,000 and the net income is 14,400.
Using the profit margin percentage formula the ratio is calculated as follows:
Profit margin ratio = Net income / Revenue Profit margin ratio = 14,400 / 120,000 = 12%
In this case the ratio indicates that the business retains 12% of each sale that it makes as net income.
Real Life Ratio Examples
The profit margin ratio will vary from industry to industry, and therefore it is important when making comparisons to determine an industry ratio based on financial statements of businesses similar to your own.
To illustrate the difference in the profit ratio from industry to industry, the following table sets out the calculation of the ratio based on the income statements of two very different companies Apple Inc., and Amazon.
Apple has a high profit margin ratio and retains 21.67% of every sale, whereas Amazon has a low margin ratio and retains only 0.37% of every sale it makes.
Profit Margin and the Financial Projections Template
We report the profit margin on the ratios page of the financial projections template. We monitor the ratio to ensure that it is consistent with the industry in which the business operates, and shows a value which is improving over time as the business becomes more efficient, gets its expenses under control, and starts to grow revenue at a faster pace than its expenses.
It is important not to confuse profit with cash. A business with a high net margin ratio does not necessarily mean that the business will not run out of cash. Profit is only one source of cash for the business, if the business ties up cash with inventory and accounts receivable or invests heavily in property, plant, and equipment, it can still be short of cash even with a high ratio.
The ratio can be calculated in a number of different ways. It is important when making comparisons year or year or for different businesses, that the ratio used has been calculated the same way. The ratio is sometimes referred to as the return on sales or the net income percentage.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.