Profit margin: how to calculate it and what makes a good one?

For startups, revenue and profit are the key performance indicators (KPIs) that indicate success.

In recent years, we have seen investors pump billions into Silicon Valley or technology companies, based on projections and estimates. They catch the headlines and illustrate investors attempts to find the next company like Apple, but many fail without coming close to making profits and investors lose money.

During periods of economic uncertainty, investors like ‘real’ numbers. Actual sales, set against costs to deliver – hopefully – profits. Within this context, the profit margin is a vital number.

What is a profit margin?

Profit margins show the relative profitability of a company by illustrating the costs involved in producing and selling goods and services and the proportion of revenue that ends in profit.

Before we explain what a profit margin is, let’s clarify the different ways profit is expressed in financial statements, as startups will see these terms used for financial reporting purposes. 

• Gross Profit

Gross profit is a measure of profitability after deducting only the cost of making a sale from revenue. This does not include other non-trading costs required to calculate other profit measurements. It is a simple calculation and does not always reveal a full picture of the success or otherwise of a business.

• Operating profit

Operating profit is a measurement based on the profit after deducting all operating costs. It is also known as earnings before interest and taxes (EBIT).  So, in addition to deducting the cost of sales, it also excludes some non-operating expenses including interest and taxes.

• Net profit

Net profit is the most commonly used and probably the most important measure of profit. Otherwise known as EBITDA (earnings before interest, taxes, depreciation and amortisation), the measure strips out all regulatory costs and expenses related to running a business as a going concern.

The profit left after stripping out all these costs shows a true measure of a business’s profitability, revealing how much of a company’s net income is generated from revenue. EBITDA is usually what investors, competitors, customers and shareholders analyse to get a true picture of company performance, financial health and its potential for growth.

• Profit margin

Profit margin itself measures the level at which a company makes money or is profitable. It is usually expressed as a percentage figure as in the example above. It illustrates the proportion of sales revenue compared to costs for a business or the amount by which revenue exceeds the costs of total sales and for net profit margin, operational and regulatory costs within a business.

What does net profit margin reveal about a business?

Revenue is an important figure but what is even more important is to know the proportion of each £ earned that is profit. If the cost of sales is higher than total revenue, the business is losing money.

If you sell a range of products, it can be beneficial to calculate net profit and net profit margin for each sales line. This reveals what product lines are the most profitable and which ones require further attention.

Investors will pay close attention to profit margins before deciding to invest in your business. For them, a low profit margin can indicate that company sales are falling, poor decisions have been made or the business needs to reduce its costs.

What represents a healthy profit margin?

This is a key question and one that is important to understand. Profit margins vary considerably depending on the type of business, what sector it operates in and other factors including how much a company has spent on investment, company acquisitions and expansion.

In general, the higher the profit margin %, the better. If its too low, for instance below 10%, your business becomes vulnerable to changes within your market or reduced sales that could result in company losses.

However, what is considered a good profit margin varies by industry. When comparing profit margins, avoid comparisons with businesses from different sectors. It’s important to compare like-for-like.

The profit margin doesn’t tell the whole story

Quite often fast-growing companies, successful by many metrics, have some financial or key performance indicators (KPI’s) that can be seen as negative.

So, for startups, what represents a healthy profit margin depends on the sector they operate in and how much they are investing in future growth and business infrastructure that will enable them to earn more revenue, with lower operating costs to grow profit margin ratios over time.

Early-stage businesses and startups often need to invest initially to grow and reach a stage where they can take on bigger projects, employ specialist staff or open up new revenue streams. This takes capital, which, if not invested, would give the business higher profit margins earlier, but might not contribute as successfully to long-term growth and profits.

Investors, accountants and other key stakeholders in your business should understand this and be able to extrapolate the key information that shows the reality behind the numbers and whether the figures are healthy or not.

This is why investors and business owners need to be cautious in comparing profit figures and profit margins for different types and sizes of businesses operating in different sectors and at varying stages of development and growth.

In summary

These case studies  illustrate three important points about profit margins and how businesses and investors employ them:

• Not all businesses will be successful
• Different industries face separate challenges that can impact what represents successful financial results and profit margins
• Investors need to analyse businesses in-depth to get the full picture of what makes a business likely to succeed.

When it comes to the profitability of a company, that’s the bottom line.