A company has the responsibility towards its shareholders. It has to report everything fair and true to its stakeholders. It is, therefore, necessary to analyze the company’s financial health from its balance sheet.

When making a portfolio, analysts first understand the profit margin of a company, before they add that company to their portfolio.

The profit margin of a company indicates how a company’s earnings reflect every dollar of the sales.

Gross profit margin
A gross profit margin of a company is a proportion of company’s profit after determining the cost of goods sold. The gross profit margin is derived by subtracting the cost of goods sold from the sales and dividing the same by the total number of sales.

The gross profit of a company is expressed in percentages of sales. For instance, a company has achieved sales of $50 million and the cost of goods sold is $30 million. Given these figures, the gross profit margin of the company derived will be $50M – $30M/$50M = 0.40 or 40%. Gross profit margin is the result of a company’s pricing strategy.

Operating profit margin
A company has to pay for other variable costs incurred such as wages and raw materials. The profit a company makes after deducting variable costs before paying any interest or tax is the operating profit margin. The operating profit margin reflects the company’s efficiency in managing costs and expenses. It is calculated by dividing the company’s operating income or profits during a given period by its net sales (also during the same period).

For instance, the company records sales of $5 million and earnings before taxes and after deducting the variable cost comes to $2 million. The operating profit margin is estimated to be $2M /$5M = 0.40 or 40%. The operating profit margin of any company differs from sectors, its cost, and the competition level. Hence, it should only be used to compare companies operating in same business.

Net profit margin
After deducting all the expenses like business operating expenses, interest expense, taxes, and preferred stock dividend incurred from the sales, whatever is left constitutes the net profit margin of a company. Net profit margin is calculated as net income divided by total sales.

For instance, the company recorded net sales of $5 million. Its net profit margin comes to 50%. A 50% net profit margin indicates that a company’s earnings are 50 cents in profit for every dollar collected.

Net profit margins differ depending on the company and industries. Having a low net profit margin does not mean low profits. It often makes the investor aware of how profitable a business is, as compared to its cash flow.

Experts believe that a company thrives on a good profit margin. A good profit margin is a sign of a healthy and growing company. Companies can increase their profit margins by increasing prices, cost-cutting, or by limiting discounts.