In accounting and financial analysis, there are often times multiple ways to describe similar concepts. Each approach, while derived from the same fundamental, provides the analyst with a different and potentially significant perspective on the numbers and the business.
The difference between net income and profit margin is an excellent and instructive example of this.
How much does a business earn?
At the end of each quarter, year, or other period, a business adds up all the revenue it brought in and subtracts all of its expenses for that period. The result of that subtraction is the business' net income. Net income is the dollar amount that the business generated from its operations.
Net income is also called profits or earnings as well, potentially confusing the matter. All of these terms, on their own, refer to the same thing. They refer to the dollar difference between a company's revenues and its expenses.
For financial analysts, higher net income is a positive for the business. A company with $1 million in net income is, obviously, generating better profits than a business earning $100,000.
But there's more to the story
The problem with analyzing net income by itself is that it doesn't give any context to the business' size, efficiency, or costs. This is particularly true when comparing a business to one of its competitors or to an industry average.
For example, what if the company that earned $1 million above did that with revenues of $50 million, while the company with $100,000 in earnings had revenues of just $1 million?
The smaller company is far more efficient, and does a much better job producing profits relative to revenues. We can quantify this using the profit margin ratio.
Profit margin is calculated by dividing the company's net income by its revenues. The result is shown as a percentage. A higher percentage means the company produces more net income for every dollar of revenue that comes in the door.
In our example, the large company has a slim profit margin of just 2%, that is, $1 million divided by $50 million. The smaller company's profit margin is a much more robust 10%.
For investors, this analysis can be very powerful. If the larger company's expenses rise just 2.04%, then the company will no longer be profitable. Likewise, a 2% decrease is sales will also erase all of its profits.
Profit margin can be used for helpful comparisons
When analyzing a company, it's important to compare performance to its industry and its competitors. That's difficult using just net income, as we saw above with our large and small companies.
But, with profit margins, we can compare companies of any size because profit margin is a relative figure. It encapsulates the relative amount of revenue and expenses, leveling the numbers for a much more useful, direct comparison.
The same is true for industry comparisons. While its all but worthless to review an industry's aggregate profits in our analysis of a specfici company, it can be very helpful to compare a relative measure, like profit margins, with the industry average.
Reviewing both net income and profit margins gives the analyst an understanding of the actual dollar performance along with the ability to give that number context relative to expenses, competitors, and the industry.
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