Everyone is familiar with the term “profit margin.” It’s one of those things you might hear in a TV show or movie about business people doing business things. You know, a term that’s accessible and that gives off that “Oooooh, businessy” vibe, but mostly doesn’t mean anything to the average person.
Well, we’re going to change that today.
There are three major “margins” that can tell you a great deal about a business. We’re gonna break down each one, learn how to calculate it straight from the income statement (one of the three main financial statements), and talk about what each one means and why it matters.
The Three Margins
Starting at the “top” of the income statement and moving down, the three margins are:
- Gross margin
- Operating margin
- Net margin
It’s easy to describe the simple equations to calculate these things, but it’s a lot more helpful to actually describe what they mean and what they imply about a particular business’s operations. So we’ll do both of those things. For this example, we’ll be using O’Reilly Auto Parts’ 2014 4th quarter income statement. You can find it here. Relevant images will be included.
Gross Margin
Ew, gross. The gross margin is the ideal place to start, as it’s the simplest to understand. Also, the stuff we need for it is conveniently located at the top of the income statement. In fact, as we march through these, we’ll go top to bottom on that statement. It really does make some sense!
Gross profit is no more complicated than revenues (what customers paid us for our stuff) minus cost of revenues, also referred to as cost of goods sold or cost of sales (what we paid to get the stuff that we sold). In Q4 of 2014, O’Reilly sold $1.764B worth of mufflers, oil, windshield wipers, tires, etc. They paid $852M to get that stuff from the muffler, oil, and tire manufacturers.
The difference between these two values gives us gross profit, as shown on the income statement below:
All the margins we have are simply a ratio between profit and revenue. So to get the gross margin, we take gross profit (what’s left over after we bought stuff from manufacturers and resold it to our customers) and divide it by revenue. To get it as a percent, of course, multiply by 100.
As we go through all these margins, keep in mind why we like to analyze based on percents and ratios. If you say “We made a million dollars gross profit last quarter,” it sounds like a lot. But if you had a billion dollars in revenue and only made a million dollars gross profit, a measly 0.1%, then your money would have been better off in a savings account, and you don’t have much of a business. Percentages scale well, which is why we like using margins. So remember that as we develop these concepts.
What Can We Learn from Our Gross Margin?
Alright, now that we know what it is, let’s talk about what we can learn about a company from this number.
As we go through the three margins, we’ll see that each one corresponds with a specific strength or weakness in our company. Within those strengths and weaknesses, we’ll see variables that we can actually play with to improve the respective margins, and therefore, the business’s overall profitability.
Gross margin corresponds with the strength of our business model. If our gross margin is too small, it could indicate one or several things. For one, it could mean we don’t generate enough revenue. That could, in turn, be caused by several sub-factors. Maybe there’s too much competition, creating excess supply and driving down prices. Or maybe the industry we’re in doesn’t have enough demand, again, lowering prices. It could mean that our product pricing is simply too low to be sustainable. All of those triggers will affect revenue.
On the other side (after all, there’s only two things in this equation), our margin could be small because the cost of goods sold is too high. That would point to the same economic factors as in revenue, but in reverse. The stuff from our suppliers might be too darn expensive, which could be because a lack of competition among those manufacturers. Or it could be that our supply chain department isn’t finding or negotiating good deals.
Whatever the case may be, you can start to see how these numbers are useful. You think, “Gross profit margin. Hm. Cool.” But savvy business leaders are looking at that number and thinking of what could be causing problems, and what to do to fix it.
Let’s move on.
Operating Margin
While gross margin says a lot about the industry environment that we’re in, operating margin can tell us a lot about our company’s internal performance.
To get to our operating margin, we need our operating profit. Also called operating income. Or income from continued operations. Or EBIT (earnings before interest and taxes). Or EBITDA (earnings before interest, taxes, depreciation, and amortization). It has a lot of names that are mostly synonymous, but what it really means is how much “background” stuff we had to do to generate our gross profit.
In O’Reilly’s case, the only line item they had was SGA (selling, general, and administrative). This includes items like rent, utilities, advertising, and employee salaries. In a different business, they may have other line items like research and development (huge for an industry like, say, pharmaceuticals). Anything that is in support of making the business work and achieving sales/revenues goes here. And we subtract that stuff from gross profit to get operating income.
O’Reilly’s operating income is shown below:
And again, to get our operating margin, we take operating income as a percent of revenue:
What Can We Learn from Our Operating Margin?
Here’s where you might not like me. While the company has some control over gross margin, it’s pretty limited by existing supply and demand, as well as competitors and manufacturers/suppliers. We have far more control over operating margin, because operating expenses are things that are totally within our walls.
Problems with operating margin usually result in actions like layoffs, store closures, and cost-cutting. And yeah, sometimes, unfortunately, those are the right things to do. Better to close a few stores or lay off a few employees than to go out of business and put everybody out of a job.
O’Reilly could put a professionally trained Formula One driver on every aisle to help customers, but it would be prohibitively expensive. It might create an awesome atmosphere and superb value for the customer, but it would probably put the company out of business fast. They could spend hundreds of millions of dollars on high-profile advertising featuring celebrities and athletes. They could buy the largest storefronts in all of the cities they’re in and have the most impressive shopping environment. But at some point, they’ve spent a whole lot of money on things that don’t really add anything, and in fact, are making the business impractical. On the flip side, we could be spending too little to get quality customer service, or create a strong product, or advertise sufficiently to generate business. Either way, these are the types of budget items you’ll see leadership fiddling with when operating margins are subpar.
Net Margin
Here we are at the final margin. We started with basic sales minus cost of sales (gross profit), added in cost of running the business and achieving those sales (operating income), and now, we’ll take out financial stuff like interest on our corporate debt and taxes that we have to pay to get net income, which, when divided by revenue like the others, produces the net margin.
Yahoo! Finance that we’ve been referencing is a little unclear on which values are positive and negative when turning operating income into net income, but you can apply a little common sense and very simple math and figure out where it comes from. “Other income” adds to operating income to get EBIT (it’s not by definition the same as operating income, but it’s typically very close, as shown here), then take away any interest we paid to creditors to get income before taxes, take away taxes and boom, net income. Easy peasy.
And for the last time, we’ll take net income divided by revenue to get our net margin.
What Can We Learn from Our Net Margin?
In addition to providing a good overall snapshot of the health of our business, the net margin indicates the strength of the company’s financial positioning. If our operating margin is good but net margin is bad, it likely indicates that we’re carrying too much debt or interest rates that we can’t handle.
Of course, the net margin is probably most often used as a summary figure. Compared to the operating margin in isolation, it gives us a feel for our financial situation, but its greatest use is that it bundles together all the indicators into one. If our net margin is solid, we probably don’t have major problems with our business model, operations, or finances. So it may seem like a simple number, but there’s a lot of information built into it!
Summary: What’s a Good Margin to Shoot For?
Okay, last thing. What makes a good margin? Well, positive is obviously one critical component for everybody, because if any of your margins are negative it means you’re not making money. Might be due to industry troubles, operating issues, or financial woes, but no matter who you are, something is wrong if these numbers are consistently negative. But beyond that, how do we know if we’re doing well?
As with many financial metrics and ratios, we’re going to make some comparisons. There are two things you want to think about when looking at margins: yourself, and your competitors. If your margins are higher than they were in the past, you know that you’re improving internally. If your margins are better than your competitor, you know you’re outperforming them. Both of these are good apples-to-apples comparisons. Some industries naturally have extraordinarily high margins; Microsoft’s net margin for Q4 2014 was 22.1% because software is typically a high margin industry. Others, like commodities (stuff you can get from almost anybody, with little differentiation), are much lower; national grocery chain Kroger’s net margin in Q4 2014 was 2.1%.
So, who would we look at to see if O’Reilly is doing well? AutoZone is a pretty obvious competitor, same space, automotive retail, and very similarly sized companies. You can bet that O’Reilly leadership is looking at AutoZone’s numbers to see how they stack up.
If you feel like it you can play CEO for the next 5 minutes and look at AutoZone’s Income Statement for the same quarter. Which margins are better/worse? What does that mean about the strengths and weaknesses of the two competing stores? If you were the CEO, looking at these numbers, what actions would you take? You now ought to be equipped with the financial tools to start answering some of these questions. Good luck!