As promised last week, we’re coming back to visit the success metric of profit margin. Profit margin is a very common ratio used to assess how much money an organization or an activity generates. Often displayed as a percentage, it represents how much of a company’s sales turn into profits.
Think about it like this: if the business is that treadmill collecting dust in your basement, Sales is how fast you’re jogging, and expenses are how fast the belt is moving. Profit margin compares the two speeds to determine if you’ll push confidently ahead or turn into an America’s Funniest Home Video as you’re spit off the back.
There are several types of profit margin (e.g. gross profit, net profit), but the phrase most often refers to net profit, or what’s left after all expenses have been accounted for. This is the “bottom line”. To clarify, I’m not wrapping up the article just yet.
I mean, the actual concept of “the bottom line” refers to net profit. It gets its name from being the literal bottom line of a business’s income statement.
The math: Net Profit Margin = (Net Income / Revenue)*100
For example, if a company sold $150,000 worth of widgets, and had $30,000 of profit left after all expenses, their net profit margin would be (30,000/150,000)*100 = 20%.
Generating profits is important for a business for several reasons:
- The obvious – it needs to be profitable at some point in order to stay alive.
- The gut punch – it needs something in reserve to survive tough times. (Hypothetical example – businesses are forced to close during a COVID lockdown).
- The incentive – starting a business is hard, risky, and expensive. If there wasn’t some hope of profit in the future, no one would do it.
Should you only invest in businesses that are profitable? Not necessarily. Some may be profitable, but don’t have a plan to stay that way. Others may be unprofitable, but with a solid plan to invest, grow, and become profitable.
The main takeaway is that profit margin can be a key component for evaluating any business. Has it been profitable? Has its profit margin trended up or down? Does it have a convincing plan to become profitable? Answers to these questions will better inform your investing decisions.