How to Calculate and Analyze Your Gross, Operating & Net Margin Ratios

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How to Calculate and Analyze Your Gross, Operating & Net Margin Ratios

Quick Summary

This article is about how to calculate and analyze profit margin ratios, specifically gross, operating, and net profit margins. Each ratio is a profitability metric used to measure business financial efficiency. A business can assess its financial health by comparing these ratios to industry averages and to its past performance. Industry profitability data can be obtained from Statistics Canada. Profitability metrics should be used alongside historical data to track trends and make data-driven decisions.

How to Calculate Your Gross, Operating & Net Profit Margin Ratios

Does your sales revenue exceed your expenses? If so, there’s a good chance your cash flow is positive and your business makes a profit.

Profitability is a key objective for every business owner—it is a core reason for starting and running a business. But looking at your profits solely as a dollar amount means you only see part of your business’s financial picture. It can’t tell you why your business is profitable or how sustainable your profitability is.

By converting different types of profit (like the company gross profit, operating profit, and net income on your income statement) into margin ratios, you can more effectively measure your financial efficiency and compare your performance with competing businesses or your business's past performance.

We show you how to calculate gross, operating, and net profit margin ratios. We also explain each profit ratio, what each means for you, and how understanding these ratios can improve your business’s financial health. Let's start with the foundations: Gross profit margin measures your company's efficiency; operating profit margin takes all operating costs into account, and net profit margin is the most comprehensive measure of profitability.

Gross Profit Margin Ratios

Your gross profit is equal to your total revenue, less the direct costs (including materials, direct labour, packaging, and shipping) of producing your goods.

Gross Profit = Net SalesCost of Goods Sold (COGS)

Gross Profit Margin = (Gross Profit / Sales) x 100

Here’s an example of the gross profit margin ratio in action.

gross profit margin

The Simple Deli sells sandwiches and coffee. For the fiscal year ending December 31, 2020, they reported total sales of $564,920, and COGS of $125,00 on their income statement. Based on those numbers, their gross profit was $439,920, and their gross margin was 77.87%. That means, for every dollar The Simple Deli generated in sales, they generated 77 cents in gross profit before other business expenses were paid. 

By looking at your direct costs only, gross profit margin shows how financially efficient your business is at turning raw materials and production labour into the goods or services you sell. Generally speaking, the higher your gross margin, the higher your profits.

You can also use a product or service’s gross margin to determine its profit potential. Here’s how that works.

The Simple Deli’s total sales in 2020 consisted of $505,400 in sandwich sales, and $59,520 in coffee sales. With a food cost of $106,400, and a beverage cost of $18,600, their gross margin on sandwiches was 78.95%, while their gross margin on coffee was 68.75%. In view of their coffee’s lower margin, the company could look to reduce their cost through bulk purchases or to increase their markup per cup. 

Operating Profit Margin Ratios

Your operating profit is equal to your total revenue, less your COGS, operating expenses (including selling and administrative expenses), and depreciation & amortization. 

Operating Profit = Gross Profit – Operating Expenses – Depreciation & Amortization

Operating Profit Margin = (Operating Profit / Sales) x 100

Here’s an example of the operating profit margin ratio in action.

operating profit margin

For the fiscal year ending December 31, 2020, The Simple Deli reported total sales of $564,920 and a gross profit of $439,920. Their operating expenses for the year were $318,960. Based on those numbers, the company’s operating profit was $120,960, and their operating margin was 21.41%. 

By taking all your costs of doing business into account, operating profit margin shows how financially efficient your business is at controlling operational costs and expenses.

While an operating margin that trends higher over time is ideal, this ratio is mainly used to compare a company’s operations with those of its competitors.

Net Profit Margin Ratios

As the last line on your income statement, your net profit is literally your company’s bottom line – and one of the most important indicators of financial health.

Net Profit = Operating Profit – Interest – Taxes

Net Profit Margin = (Net Profit / Sales) x 100

Here’s an example of the net profit margin ratio in action.

net profit margin

For the fiscal year ending December 31, 2020, The Simple Deli reported total sales of $564,920 and an operating profit of $120,960. They also had income tax owing of $45,099. Based on those numbers, their net profit was $75,861, and their net margin was 13.43%.

Because it takes all your costs into account, net profit margin is the most granular and conclusive profitability metric

Final Thoughts

While the ideal net profit margin varies with industry and company size, 10% is a reasonably good average for most businesses. Meanwhile, any profit ratio above the average for an industry can be considered a competitive advantage.

If you want to improve your net company profit margin, increase sales, reduce expenses, or do both! Higher sales often mean higher total expenses. To cut business costs, it may be a good idea to outsourcing certain tasks - like bookkeeping or HR, for example - to cut costs

Remember, just because your business is profitable dollar-wise doesn’t necessarily mean it’s financially healthy.

Using profitability metrics in conjunction with your historical data will help you:

  • Conduct year-over-year comparisons
  • Monitor your overall financial performance
  • Make better, data-driven decisions

The only way to calculate and analyze your gross, operating & net margin ratios is with an accurate set of books. If you need help bringing your financial data up to date, Enkel can help.

Omar Visram
About Omar Visram
Omar Visram is the Co-founder and CEO of Enkel Backoffice Solutions Inc. Headquartered in Vancouver, Enkel provides bookkeeping, payroll, accounts payable and accounts receivable services to over 300 organizations Canada-wide.