Let's face it, a company's most important goal is to make money and keep it, which depends on liquidity and efficiency. Because these characteristics determine a company's ability to pay investors a dividend, profitability is reflected in share price.

That's why investors should know how to analyze various facets of profitability, including how efficiently a company uses its resources and how much income it generates from operations. Knowing how to calculate and analyze a corporate profit margin is a great way to gain insight into how well a company generates and retains money.

Analyzing Corporate Profit Margins Using Profit-Margin Ratios

It's tempting to rely on net earnings alone to gauge profitability, but it doesn't always provide a clear picture of a company. Using it as the sole measure of profitability can be a bad idea.

Profit-margin ratios, on the other hand, can give investors deeper insight into management efficiency. But instead of measuring how much a company earns from assets, equity, or invested capital, these ratios measure how much money a company squeezes from its total revenue or total sales.

Margins are earnings expressed as a ratio or a percentage of sales. A percentage allows investors to compare the profitability of different companies, while net earnings, which are presented as an absolute number, don't.

Example of a Profit-Margin Ratio

Suppose that Company A had an annual net income of $749 million on sales of about $11.5 billion last year. Its biggest competitor, Company B, earned about $990 million for the year on sales of about $19.9 billion. Comparing Company B's net earnings of $990 million to Company A's $749 million shows that Company B earned more than Company A, but it doesn't tell you very much about profitability.

However, if you look at the net profit margin or the earnings generated from each dollar of sales, you'll see that Company A produced 6.5 cents on every dollar of sales, while Company B returned less than 5 cents.

There are three key profit-margin ratios: gross profit margins, operating profit margins, and net profit margins.

Gross Profit Margin 

The gross profit margin tells us how much profit a company makes on its cost of sales, or cost of goods sold (COGS). In other words, it indicates how efficiently management uses labor and supplies in the production process. This is the formula:

Gross Profit Margin = (Sales - Cost of Goods Sold)/Sales

Suppose that a company has $1 million in sales and the cost of its labor and materials amounts to $600,000. Its gross margin rate would be 40% (($1 million - $600,000)/$1 million).

Companies with high gross margins will have money left over to spend on other business operations, such as research and development or marketing. When analyzing corporate profit margins, look for downward trends in the gross margin rate over time. This is a telltale sign the company may have future problems with its bottom line.

For example, companies frequently are faced with rapidly increasing labor and materials costs. Unless the company can pass these costs onto customers in the form of higher prices, these costs could lower the company's gross profit margins.

It's important to remember that gross profit margins can vary drastically from business to business and from industry to industry. For example, the software industry has a gross margin of about 90%, while the airline industry only has a gross margin of about 5%.

Operating Profit Margin

By comparing earnings before interest and taxes (EBIT) to sales, operating profit margins show how successful a company's management has been at generating income from the operation of the business. This is the calculation:

Operating Profit Margin = EBIT/Sales

If EBIT amounted to $200,000 and sales equaled $1 million, the operating profit margin would be 20%.

This ratio is a rough measure of the operating leverage a company can achieve in the operational part of its business. It indicates how much EBIT is generated per dollar of sales. High operating profits can mean the company has effective control of costs, or that sales are increasing faster than operating costs.

Knowing operating profit also allows an investor to do profit-margin comparisons between companies that do not issue a separate disclosure of their cost of goods sold figures. Operating profit measures how much cash the business throws off, and some consider it a more reliable measure of profitability since it is harder to manipulate with accounting tricks than net earnings. Naturally, because the operating profit margin accounts for administration and selling costs as well as materials and labor, it should be a much smaller figure than the gross margin.

Net Profit Margin 

Net profit margins are those generated from all phases of a business, including taxes. In other words, this ratio compares net income with sales. It comes as close as possible to summing up in a single figure how effectively the managers are running a business:

Net Profit Margins = Net Profits After Taxes/Sales

If a company generates after-tax earnings of $100,000 on $1 million of sales, then its net margin amounts to 10%.

To be comparable from company to company and from year to year, net profits after tax must be shown before minority interests have been deducted and equity income added. Not all companies have these items. Also, investment income, which is wholly dependent upon the whims of management, can change dramatically from year to year.

Just like gross and operating profit margins, net margins vary between industries. By comparing a company's gross and net margins, we can get a good sense of its non-production and non-direct costs like administration, finance, and marketing costs.

Examples of Corporate Margin Analysis

As part of its annual financial statement reporting, Microsoft reported financial information for the year ending June 30, 2022. These comparative income statements also communicated historical results for the same period ending in 2021 and 2020.

Based on the section above, Microsoft generated $198.27 billion of revenue in 2022. Looking further down its income statement, it also generated $135.6 billion of gross margin. Dividing Microsoft's gross margin by its total revenue yields roughly 68%; this means that for every dollar Microsoft generated in income, it paid roughly $0.32 for cost of goods sold and kept $0.68 to pay for broader operations.

Looking further down the income statement, Microsoft also reported operating income of $83,383. This equals roughly 42% of net total sales. This means that after Microsoft paid for both its cost of goods sold and operating costs, it still kept $0.42 from every dollar it earned.

Last, Microsoft paid income taxes and had several income statement lines that further reduced the amount of net income it earned. Rounding up, this left Microsoft with roughly 37% of its total gross revenue. This means that for every dollar that Microsoft sold, it ultimately kept $0.37 after factoring in costs. Consider that by itself, these margin ratios may not mean much. After all, you may not know if a 37% net income margin is good, especially considering Microsoft's size, industry, and competitive advantages. Therefore, margin ratios are a tremendous way to compare information across companies to see how one entity may be performing against its competitors. Last, consider the value profit margins may offer by comparing them over time. Looking at Microsoft's financial information above, the company posted a 45.6% net income margin in 2020 and 52.8% net income margin in 2021. Therefore, though 37% may sound high, performing comparative margin analysis may reveal potential trends or downturns.

The Bottom Line

Margin analysis is a great tool to understand the profitability of companies. It tells us how effective management can wring profits from sales, and how much room a company has to withstand a downturn, fend off competition, and make mistakes. But, like all ratios, margin ratios never offer perfect information. They are only as good as the timeliness and accuracy of the financial data that is fed into them. Correct analysis also depends on a consideration of the company's industry and its position in the business cycle.

Margin ratios highlight companies that are worth further examination. Knowing that a company has a gross margin of 25% or a net profit margin of 5% tells us very little. As with any ratio used on its own, margins tell us a lot, but not the whole story, about a company's prospects.