The profit margin ratio, also called the return on sales ratio or gross profit ratio, is a profitability ratio that measures the amount of net income earned with each dollar of sales generated by comparing the net income and net sales of a company. In other words, the profit margin ratio shows what percentage of sales are left over after all expenses are paid by the business.
Creditors and investors use this ratio to measure how effectively a company can convert sales into net income. Investors want to make sure profits are high enough to distribute dividends while creditors want to make sure the company has enough profits to pay back its loans. In other words, outside users want to know that the company is running efficiently. An extremely low profit margin formula would indicate the expenses are too high and the management needs to budget and cut expenses.
The return on sales ratio is often used by internal management to set performance goals for the future.
Formula
The profit margin ratio formula can be calculated by dividing net income by net sales.
Net sales is calculated by subtracting any returns or refunds from gross sales. Net income equals total revenues minus total expenses and is usually the last number reported on the income statement.
Analysis
The profit margin ratio directly measures what percentage of sales is made up of net income. In other words, it measures how much profits are produced at a certain level of sales.
This ratio also indirectly measures how well a company manages its expenses relative to its net sales. That is why companies strive to achieve higher ratios. They can do this by either generating more revenues why keeping expenses constant or keep revenues constant and lower expenses.
Since most of the time generating additional revenues is much more difficult than cutting expenses, managers generally tend to reduce spending budgets to improve their profit ratio.
Like most profitability ratios, this ratio is best used to compare like sized companies in the same industry. This ratio is also effective for measuring past performance of a company.
Example
Trisha’s Tackle Shop is an outdoor fishing store that selling lures and other fishing gear to the public. Last year Trisha had the best year in sales she has ever had since she opened the business 10 years ago. Last year Trisha’s net sales were $1,000,000 and her net income was $100,000.
Here is Trisha’s return on sales ratio.
As you can see, Trisha only converted 10 percent of her sales into profits. Contrast that with this year’s numbers of $800,000 of net sales and $200,000 of net income.
This year Trisha may have made less sales, but she cut expenses and was able to convert more of these sales into profits with a ratio of 25 percent.
