Profit Margins

         Gross Profit Margin = Gross Profit

                                       Net Revenue

The Gross Profit Margin expresses gross profit as a percentage of sales.  Gross profit is what remains after cost of good sold (or direct costs) are subtracted from revenues.

Note that net (as opposed to gross) revenue is used in the denominator of profit margins.  Sometimes a company will express “gross sales” less “returns and allowances,” equaling “net sales” on their income statement.  When a business presents both gross and net revenues, it is net revenues that are used in profit margins and common size reports.

A higher percentage (or profitability) is obviously desirable for this ratio.  The gross profit margin can be an invaluable indicator of performance and profitability (or pricing strategy) when compared with other firms in the industry.  It is among the most basic and widely used financial ratios.

         Operating Profit Margin = Operating Profit

                                                 Net Revenue

The Operating Profit Margin expresses operating profit (or net sales, less cost of sales, less operating expenses) as a percentage of net sales.  This is also a crucial measure of profitability, which is often compared to industry averages.

Company profit margins are also compared year over year, and trends are studied by management and financial analysts.

In this Street Smarts article on Inc.com, Norm Brodsky argues that the gross profit margin is the most important number on the income statement (http://www.inc.com/magazine/20081001/street-smarts-secrets-of-a-110-million-man.html).