Term of the Day: Profit Margin

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Gross Profit.jpg

The term of the day that we will examine today is the profit margin. The profit margin is an important analytic tool that investors can use to make educated investing decisions. The profit margin is very important as it provides an accurate indication of a company's pricing strategy in relation to its costs of operation.

Definition: Profit Margin refers to the percentage of a company's revenue that remains after all costs, taxes, interests, depreciation, and other expenses have been deducted.

Explanation

The profit margin provides a clearer insight into a company's profitability beyond what you can see from the company's sales, revenue and earnings. The profit margin tells us how much profit a company stands to make from a volume of sales.

For instance, company X might record sales of 100 million Naira with net income of 10 million Naira while company Y recorded sales of 200 million Naira with net income of 20 million Naira. A cursory glance at the sales of company X and company Y will show that company Y has more revenue at 200 million Naira than company X at 100 million Naira.

However, the profit margins will show you that company Y has a profit margin of 7.5% on its 200 million Naira sales while company X has a profit margin of 10% on sales of 100 million Naira. Hence, company X with the lower volume of sales is actually more profitable that company Y with the higher sales volume.

In addition, the profit margin can provide insight into a company's profitability at different points in time. For instance, company X might record sales of 100 million naira with net income of 10 million naira in the first quarter and then, the sales jumps to 200 million naira with net income of 20 million naira in the second quarter. We can easily see that the company had a profit margin of 10% in the first quarter and a profit margin of 7.5% in the second quarter.

Why You need to Understand the Profit Margin

It is easy for investors to be carried away when a company delivers impressive sales/revenue and thus, they might forget to ask the important questions about the company's profitability.

In addition, an understanding of the profit margin will help you measure the level of profitability of different companies operating within the same sector or industry.

Lastly, the profit margin can help you know how well a company is able to manage its cost of operations such that its cost price does not equal or become more than its selling price.
 
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