Day 12 of Fundamental Investing
Next, in the Profitability Ratio is the Profit Margin Ratio.
What is it?
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 would indicate the expenses are too high and the management needs to budget and cut expenses.
How to calculate it?
Here's an image for the same:
What's its significance?
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.
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