What are Margin Ratios?
Margin ratios measure a company’s ability to turn its sales into profits. Standalone figures provide only a snapshot and are in some way meaningless without a benchmark. Margin ratios have applications in valuation, credit analysis, and company performance.
Key Learning Points
- Margin ratios help analyze the relationship between a company’s earnings or profits and sales
- Key profitability ratios are Gross margin, EBIT margin, EBITDA margin, and net margin
Margins present a company’s profits as a percentage of its sales and are useful for comparison to peers. Below are the most common margins:
Gross margin tells us how much profit remains after removing the direct cost of sales, COGS, but before less direct costs like sales and marketing. Typically, a company with high value add like a service company will have a high gross margin, while a trading business adds less value to the product and therefore typically has low gross margin.
Gross margin = Gross Profit / Sales
Earnings before interest and taxes (EBIT) is a figure which shows the profitability of a company from its operations after excluding non-recurring items. Excluding these items can improve comparability as well as providing a useful starting point for predicting future profitability.
EBIT margin helps to understand the profits generated from a company’s core operations and ignores the effects of a company’s financing decisions and taxes.
EBIT Margin = EBIT / Sales
EBITDA margin shows the recurring operating profit before the impact of depreciation and amortization as a percentage of sales. Depreciation and amortization expenses can vary between companies depending on their accounting policies. Using EBITDA removes this effect.
EBITDA Margin = EBITDA / Sales
Net margin measures the company’s net income as a percentage of revenues. is the profit after all expenses have been deducted for the period. Net margin is calculated as:
Net margin = Net income / Sales
Net income can be affected by one-time gains or losses. For valuation purposes, an analyst will “clean” the net income and remove the impact of non-recurring items.