In our last blog, we talked about EBITDA and EBITDA margin, and stated that it is better to use both GAAP metrics and EBITDA to determine an organization’s financial health.
Under the guidelines of GAAP (generally accepted accounting principles) requirements for corporate accounting, a profit margin is calculated using one of the three principles: gross profit margin, operating profit margin or net profit margin. These are indicators of a business’s financial health because GAAP standardizes profit margins. Net profit margin is often used as a good indicator for evaluating profitability based on expenses and revenues.
Now we will outline the differences between gross, net, and operating profit margins as related to revenue.
What is revenue?
Revenue or sales revenue is the general business income earned during a period of time, usually from the sale of goods and services to customers. Revenue is also referred to as sales.
What is gross profit/income?
After subtracting the cost of goods sold and sales returns/allowances from total sales revenue is the gross profit.
What is operating profit/income?
Operating Income = Gross Income − Operating Expenses
Operating expenses are the costs of running the day-to-day operations, including SG&A, depreciation, and amortization, and other operating expenses. Operating income includes more expense line items than gross profit, which primarily includes the costs of production.
Operating income allows management and investors to see a company’s operating performance.
Operating income is the income from core operations. Operating income does not include any income and expenses not directly tied to the core business, investments in other businesses (non-operating income), taxes, interest expenses, non-recurring payment such as a lawsuit settlement, and non-operating expenses which are included in the net income calculation.
What is net profit/income?
Net profit is the amount of profit after paying off all its expenses/costs such as “cost of goods sold” (COGS), “selling, general and administrative expenses” (SG&A), depreciation, and amortization, interest expense, taxes and any other expenses.
Net profit is the bottom line of a company’s income statement, which are also called “Net Income” or “Net Earnings”.
What is a profit margin?
A profit margin measures profits in relation to a company’s revenue. Three primary margin ratios are used to determine profitability: gross, operating, and net. They are expressed as a percentage rather than as a monetary value used for income.
- Gross profit margin (total revenue minus COGS),
- Operating profit margin (revenue minus COGS and operating expenses),
- Net profit margin (revenue minus all expenses, including interest and taxes).
Profit margin formula
- Gross Profit Margin = Gross Profit / Revenue x 100
- Operating Profit Margin = Operating Profit / Revenue x 100
- Net Profit Margin = Net Income / Revenue x 100
Gross profit margin
Gross profit margin is the difference between revenue and cost of goods sold (COGS) divided by revenue. It can be used as the selling price of a product or service, minus the direct cost of goods sold such as manufacturing, production or acquisition costs, but not accounting for indirect fixed costs such as overheads, office expenses, rent, utilities, freight, payroll or administrative costs.
Operating profit margin
Operating profit margin is the ratio of operating income (or “operating profit”) to net sales, as a percentage. It is also known by other names such as “operating margin”, “operating income margin”, “EBIT margin” and “return on sales (ROS)”.
Operating profit margin describes a company’s operating efficiency.
Net profit margin
Net profit margin measures net income or profit as a percentage of revenue. Net profit margin is also called net margin. Net profit margin helps to assess profitability from sales and for managing operating costs and overhead costs. Net profit margin is one of the most important indicators of a company’s financial health, for evaluating the effectiveness of a business’ practices, as a track record over time for the company’s own growth and for comparing the profitability of two or more businesses regardless of size. It helps management and investors see if operating costs and overhead costs are under control.
It’s best to utilize several financial metrics when analyzing a company. Net profit margin should be used with gross profit margin and operating profit margin.
a2zCFO, both the Right and Left Arms for your organization:
As a consulting CFO, I set up profits and loss statements to easily derive profit margins and help business owners and management “keep your ship on course.”
We help with any aspect of financial management from A to Z. By providing trusted financial advice, I create financial and goal clarity, resulting in increases in cash, profitability and sales all the while preparing the business strategically for a successful exit when the time is right.
- Works at client’s location and directly with client’s staff;
- Affordable and flexibility in hours – 4 hours a month to short term full time assignment;
- Excels at messy and difficult clean up situations;
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Please call me (925) 216-5058 or email: rolf@a2zCFO.com
A2Z CFO, we keep your ship on course.