Business Financials 101 – Business Health Ratios – The Profit and Loss Statement and Profit Margins

All businesses report how the business is going on the Profit & Loss Statement or Income Statement, and from it we can calculate Business Health Ratios that give us insight to the financial health of the business. The statement shows all the sales for a period less cost of goods (if you sell product) leaving gross profit, then from that all the expenses (operating or overheads like rent, wages etc) leaves  the operating profit (not always reported), then from that less any non-regular income and expenses, gives us the final net profit.

In summary, there are three main levels of profit or profit margins –

Gross profit (after cost of sales deducted from sales/revenue),

Operating profit (sometimes given = after expenses deducted) also known as Pretax profit (before tax and other non-regular items) and

Net profit (Final, after tax and other non-regular expenses and income).

Note that “profit”, “earnings” and even “income” are all used interchangeably, and mean the same thing.

When the term “margin” is stated, it can apply to the absolute dollar number for a given profit level and/or the number as a percentage of sales/revenues.

The absolute amount, the dollar amount, is on the Profit & Loss Statement. The net profit margin commonly uses the percentage calculation to provide a measure of a company’s profitability on a historical basis (3-5 years) and in comparison to peer companies and industry benchmarks. The margin is the amount of profit (at the gross, operating, pretax or net level) as a percent of the sales generated.

So the calculation for –

Gross Profit Margin is Gross Profit / Sales (ie GP divided by sales).

Operating Margin is Operating Profit / Sales (ie OP divided by sales), and so on.

The observation of profits over years can detect consistency or positive/negative trends in a company’s earnings. Positive profit margin analysis translates into positive investment quality. To a large degree, it is the quality, and growth, of a company’s earnings that drive its stock price, as well as earnings per share and Return on Equity.