Finance guide: What is a good profit margin?
Learn how to use the most common profit margin formulas and why a good profit margin increases company value.
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1 minute
August 20, 2024
A small business owner can measure profitability in several ways, and profit margin formulas help managers assess business performance.
This post explains using profit margin formulas and other metrics to analyze business results. You’ll learn the best practices for calculating profitability, and how to determine what is a good profit margin.
Key highlights:
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Ken Boyd is a guest contributor. The views expressed are his and do not necessarily reflect the views of Rho.
Profit margin is defined as net income divided by sales, and the ratio calculates the profit earned on each dollar of sales. Successful companies may generate higher profit margins than the industry average and work to increase revenue and reduce expenses to improve the bottom line.
Businesses can use several different profit margin formulas to assess performance. To explain each type of profit margin, here is the Quality Beverages’ 2024 income statement:
The income statement is generated using this formula:
The multi-step income statement presented here includes additional line items for operating expenses, cost of goods sold (COGS), and other account balances.
For this example, revenue and sales are the same amount. Some financial metrics use net sales, a balance calculated as sales less returns, allowances, and discounts.
The net profit margin compares net income to total revenue. Net profit can also be defined as net income. The formula is:
The ratio is multiplied by 100 to convert the number into a percentage. Quality Beverages’ net profit margin is:
Net margin reports the lowest margin percentage because all expenses are subtracted from net income.
Gross profit is calculated as revenue less the cost of goods sold.
The cost of goods sold includes direct costs (raw materials and labor) and other production costs incurred to produce a product or service. Indirect costs (overhead costs) are excluded from the cost of goods sold.
Here is the gross profit margin formula:
Quality’s gross profit margin is:
Companies focusing on the cost of goods sold may prefer the gross profit margin. Many businesses attempt to reach a specific gross profit level and then minimize other expenses to reach an overall profitability goal.
Operating profit is computed as revenue less the cost of goods sold and operating expenses.
Operating expenses are costs that are not directly tied to production. These costs include advertising and marketing expenses, rent, utilities, and depreciation expenses. Operating profit is also earnings before interest and taxes (EBIT). The operating profit margin formula is:
Quality’s operating profit margin is:
Net profit margin is the most complete measure of profit margin because all expenses are included in net income. The gross profit margin does not include operating expenses and other costs.
The operating profit margin does not include interest expense and tax expense. Operating margin includes more expenses than gross profit margin but less than net profit margin. A healthy profit margin varies for different industries.
Business owners can use any of the formulas to determine financial health. However, businesses should use the same formulas to make decisions about operating costs, pricing strategy, and sales over time. When the same formula is used, finance teams can better analyze trends.
A good gross profit margin depends on your company’s industry and how long the business has operated. Generally speaking, a 10% profit margin is average and a 20% or higher profit margin is good.
Here are some benefits of generating a good profit margin:
Businesses that produce a higher profit margin than the competition can better position themselves to find new customers and increase total sales. Many companies with a lower profit margin might not generate excess profits to fund expansion.
Investors, lenders, and other stakeholders value business predictability.
Established companies can plan revenue and expenses based on industry experience. They have brand awareness with customers and generate repeat business. These businesses are more likely to produce a consistent profit margin.
New businesses don’t generate consistent profits, and planning is more difficult. Consider these factors:
It may take years for these firms to produce a steady business profit.
The NYU Stern School of Business tracks profit margins by industry. Here are the gross margins for several industries:
Industry disruptions, such as the pandemic, can change the average profit margins for an industry. When consumer preferences change, high-margin products may no longer be in demand.
SMBs can improve a low-profit margin by reducing costs, increasing prices, and implementing other strategies. Profits can be increased to an average net profit margin with effective management.
Review all costs, and identify areas where costs can be reduced. Here are some cost strategies:
If some of your products or services are in high demand, you can increase prices while maintaining the same level of sales. Experiment with price increases and evaluate the impact on sales. If sales decline, use the original price.
Focus on customer retention, particularly clients who generate recurring revenue. Increase customer loyalty by offering discounts and other rewards for repeat purchases. Bundle related products and market them to increase average order value.
If you increase sales to repeat customers, you can grow the business without a large investment in marketing and advertising costs.
Make a consistent effort to improve profit margins.
Founders and managers also use these metrics to assess business performance:
A profitable business should be able to collect cash to fund operations. These metrics analyze how cash inflows and outflows.
Days sales outstanding (DSO) ratio is the average number of days required to convert all credit sales into cash. The formula is 365 days X (average accounts receivable divided by net credit sales).
To compute DSO, assume that the average accounts receivable balance is $220,000 and that net credit sales total $800,000. The DSO calculation is:
An increasing DSO ratio means that cash collections are slowing and the business may experience a cash shortage.
Days Payable Outstanding (DPO) ratio calculates the average number of days required for a company to pay its accounts payable balance. The formula is 365 days X (average accounts payable divided by the cost of goods sold).
To compute DPO, assume the average accounts payable balance is $100,000 and the cost of goods sold is $431,667. The calculation is:
Both DSO and DPO are calculated based on days. DSO addresses collections and DPO analyzes payments.
Turnover ratios estimate how quickly the business collects cash from customers and how quickly the business pays suppliers. Turnover ratios compute a rate, rather than the number of days.
Higher turnover ratios mean that collections (or payments) move faster.
Net present value (NPV) totals future cash inflows and outflows and discounts the cash flows to present value. If a project generates net cash inflows, the company may invest in the project.
Management selects a discount rate based on current interest rates or a desired rate of return. The internal rate of return (IRR) is the discount rate that calculates the NPV of all future cash flows as zero.
These ratios analyze the balance sheet, income statement, and cash flow performance:
The current ratio (working capital ratio) is (current assets divided by current liabilities). A business needs a current ratio of 1 or greater so that current assets are at least equal to current liabilities.
The pretax margin ratio is earnings before taxes divided by revenue. Quality Beverages’ ratio is:
The operating cash flow margin is the operating cash flow divided by revenue. Operating cash flow includes cash inflows and outflows from day-to-day operations, such as purchasing inventory, collecting customer payments, and processing payroll.
The earnings before interest, taxes, depreciation, and amortization (EBITDA) formula is EBITDA divided by revenue. EBITDA is a popular metric to measure profitability, and many firms use the margin.
The price-to-sales ratio is used to assess business investments. The formula is market capitalization divided by revenue for the past 12 months. Market capitalization is computed as the number of outstanding shares multiplied by the market price per share.
Well-managed businesses maximize the profit generated from the equity and assets on the balance sheet.
ROE measures how well a company uses equity to generate a profit. The formula is (net income - preferred stock dividends) divided by the average equity balance.
ROA calculates profit compared to assets used to produce revenue. The formula is net income divided by total assets.
Cash flow yield is computed as free cash flow per share divided by the current market price per share. Free cash flow is cash available after paying operating expenses and capital expenditures.
The dividend yield is the dividend paid per share divided by the current market price per share. Investors who want to earn income on a stock portfolio often purchase stocks with a high dividend yield.
Return on invested capital is calculated as net operating profit after tax (NOPAT) divided by invested capital. This ratio measures how well a business uses capital to generate profits.
The criteria for a good profit margin depends on your company’s industry and how long the business has operated. Generally speaking, a 10% profit margin is average and a 20% or higher profit margin is good.
A bad profit margin is a percentage that is below your industry average. If you can’t generate the same level of profit as many competitors, business expansion is difficult.
Small businesses should generate a profit margin at or above the industry average. However, small businesses may not have enough capital to take market share from larger competitors.
The NYU Stern School of Business tracks profit margins by industry, and Stern’s retail categories include e-commerce. The gross profit margin is 30.0% for specialty lines, 30.8% for general retail, and 32.3% for distributors.
Profit margin is defined as net income divided by sales, and the ratio calculates the profit earned on each dollar of sales. Many successful companies generate higher profit margins than the industry average.
A fair or reasonable profit is a level that meets or exceeds the industry average. A profit margin of 5% or less is risky, because slight changes in business conditions may generate a loss.
Profit margin analysis helps you make informed financing decisions. What is a good profit margin? The answer depends on your specific industry.
Successfully generating profit margin metrics necessitates clean data; however, obtaining this level of data can require numerous hours. Leverage technology to save time.
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