Profit is one of the most important metrics when conducting a financial analysis of your business. Your company’s ability to generate profit can be a positive indicator of its financial health—if you accurately calculate it in relation to your expenses.
“Managers can increase the value of a company by improving its profitability and growth,” says Harvard Business School Professor Suraj Srinivasan, who teaches the online course Strategic Financial Analysis. “To do this, they can focus on one or more of the following drivers of value—they can grow revenues; they can improve operational effectiveness; they can increase the efficiency of the firm’s investments; and they can impact the financing strategy of the firm.”
Ratio analysis provides context to these value drivers and allows you to compare performance over time or across companies. To conduct it, you can use tools like margin ratios, which help measure a company’s profits. Here’s how to start calculating your organization’s profit margins.
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DOWNLOAD NOWCalculating Profit Margins Through Margin Ratios
Profit margin is a measure of the income remaining after costs are deducted from sales revenue. It’s expressed as a percentage and calculated using an equation known as a margin ratio. A higher margin indicates greater profitability and efficiency.
Why is it critical to calculate your profit margin? In Strategic Financial Analysis, Srinivasan uses the example of streaming platform Netflix to show how margin ratios provide the necessary data to evaluate profitability over time.
“Netflix launched its self-produced shows in 2012,” says Srinivasan in Strategic Financial Analysis. “In the following decade, its revenues grew rapidly along with its costs. If you compare its cost-to-revenue ratio, you’ll notice that the ratio actually dropped from 73 percent to 61 percent, leading to an increase in its overall profitability. Ratios like this allow us to assess how growth translates into profitability.”
When implementing this strategy in your business, you can utilize several different margin ratios—each providing various benefits and specializations depending on your goals.
Types of Margin Ratios
While all margin ratios compare a company’s income or revenue to its costs and expenses, the specific variables can vary widely. For example, suppose you compared the cost of creating a single product to how much you made selling it. In that case, you’d have a significantly different margin ratio than if you compared your company-wide sales to the full scope of your operating costs.
Different margin ratios allow you to analyze your operational efficiencies, compare your profitability to competitors’, and better understand the relationship between the money coming into your business and the money going out. This, in turn, can help you improve your overall profit margin.
There are a variety of margin ratios. Gross, operating, EBITDA, and net profit margins are explained in depth in Strategic Financial Analysis and defined as follows:
1. Gross Margin
Gross margin is a simple calculation that determines the percentage of sales revenue your business retains after deducting the costs directly associated with producing or delivering those sales. This can apply to goods or services, depending on the nature of your business.
The formula for determining your organization’s gross margin is:
[Sales - Cost of Goods Sold] / Sales
2. Operating Margin
While a gross margin ratio can provide a basic estimation of your company’s profits, it fails to consider certain business costs—the first and foremost being operating costs.
As explained in Strategic Financial Analysis, operating margins account for these additional expenditures by calculating the percentage of sales retained after paying for all operating expenses. This formula is often used to determine how much of a company’s profits come from its core operations rather than other revenue streams, such as investing.
The formula for determining your business’s operating margin is:
[Sales – Cost of Goods Sold - Other Operating Expenses] / Sales
3. EBITDA Margin
Strategic Financial Analysis helps you better understand your company’s short-term operational efficiency by leveraging the EBITDA margin. While operating margins include all operating expenses, EBITDA margins exclude all non-operating expenses by first calculating your Earnings Before Interest, Tax, Depreciation, and Amortization. Here’s a breakdown of each component:
- Earnings before interest: Measures a company’s profitability without factoring in interest expenses
- Tax: A monetary charge imposed on a company
- Depreciation: The decrease in an asset’s value over time, reflecting how much of the asset’s value has been used
- Amortization: Spreads the cost of intangible assets—such as trademarks and copyrights—over their useful lifespan
The formula for determining your business’s EBITDA margin is:
[Net Income + Taxes + Interest Expense + Depreciation + Amortization] / Sales
Remember: Net income is calculated by [Revenue – Cost Goods Sold - Expenses]
Note that while your EBITDA margin is a useful metric to determine your operational profitability internally, it’s not recommended for external uses, such as investor interactions, as it ignores core costs to focus exclusively on in-house operations.
4. Net Profit Margin
While EBITDA margins run the risk of presenting investors with an incomplete view of your company’s profits, net profit margins do the opposite.
The formula for determining your business’s net profit margin is:
[Net Income / Sales]
Net income comprises the money your business has left after you’ve covered your expenses—including the non-operational expenses that EBITDA margins exclude—making it the most thorough summary of your company’s profitability.
| Ratio | Formula |
| Gross Margin | (Sales - Cost of Goods Sold) / Sales |
| Operating Margin | (Sales - Cost of Goods Sold - Other Operating Expenses) / Sales |
| EBITDA Margin | (Net Income + Taxes + Interest Expense + Depreciation + Amortization ) / Sales |
| Net Profit Margin | Net Income / Sales |
Related: 2 Ways to Increase Profit Margin Using Value-Based Pricing
Margin Ratios in the Real World
Margin ratios can be better absorbed through the lens of real-world business challenges, as explored in Strategic Financial Analysis. The course examines the profit considerations for industry-leading chip manufacturer NVIDIA.
Between 2017 and 2022, the research and development (R&D) cost increased from 18.5 percent to 27.2 percent of NVIDIA’s sales. During this time, NVIDIA’s gross margin ratio remained on par with its competitors, while its net income profit margin lagged. This confirmed an operational expense, such as research, could be the cause.
Considering NVIDIA is a major player within an industry based on innovation, the company could easily make the case that the increased R&D was well worth the investment in the long run. However, by comparing different margin ratios, they could also identify ways to improve their profitability without hindering R&D. For example, they could audit current development projects and cancel those without the potential to make it to market.
Mastering Margin Ratios
Margin ratios provide business insights far beyond their initial profitability measurements. They are vital diagnostic metrics that can help you identify growth areas, calculate your bottom line, and increase your company’s overall valuation.
Understanding margin ratios equips you to help your company remain profitable in changing financial conditions.
Learn more about these concepts and how to forecast financial performance by taking an online finance course, such as Strategic Financial Analysis. Through interactive learning exercises and real-world examples featuring experienced finance executives from dynamic companies worldwide, you can gain practical knowledge to implement immediately in your business.
Do you want to learn essential financial concepts and drive business performance? Explore Strategic Financial Analysis, one of our online finance and accounting courses. If multiple programs interest you, consider pursuing a Learning Track, which enables you to take three courses within the financial and accounting subject area. Are you wondering which HBS Online finance and accounting course to start with? Download our free flow chart to determine which best aligns with your experience and goals.
