A profit margin is an indicator of profitability, expressed as a percentage. Net profit margins show how much revenue is retained after all costs and taxes are paid. There are simple formulas for calculating each. Let’s have a look at the basics.
How Do I Calculate Profit Margins?
In order to figure out a profit margin, you need to know your business’s net income and revenue. You can then find the profit margin with the formula:
Profit Margin = (Net Income √∑ Revenue) x 100
Find Net Income (loss)
Net Income is reported on Form T2125 of the income tax return for your business. Recall that if your business is incorporated, a corporate tax return is required. Members of a partnership can also find their net income amount on the T5013 Statement of Partnership Income slip. Net income is what remains after other partners subtract their shares of the income.
First, determine your gross business or professional income or your gross profit. These amounts are entered on line 8299 of Part 3C or line 8519 of Part 3D on the T2125 form. Business income may include gross sales, commissions or fees. Professional income may include gross professional fees including work-in-progress (WIP). Gross profit may include gross business income, minus costs incurred for:
- Opening inventory* (include raw materials, goods in process, and finished goods)
- Purchases during the year (net of returns, allowances, and discounts)
- Direct wage costs
- Cost of goods sold
- Overhead costs
- Subcontracts
- Other costs
- Changes in inventory at the end of the fiscal period (including raw materials, goods in process, and finished goods).
* Be sure to follow the CRA's guidelines for inventory valuation. For each item, determine the cost at which it was acquired and the fair market value. Use the lower amount for tax purposes. For the entire end-of-year inventory cost, use fair market value at the end of the year.
Can I Deduct Business Expenses?
Fortunately, business expenses can be deducted from your total income. In many cases, those expenses are fully deductible. Others can’t be deducted dollar for dollar, but you still get a tax break for paying them. Thus, it's a good idea to add up the business expenses incurred for:
- Advertising
- Meals and entertainment
- Bad debts
- Insurance
- Interest and bank charges
- Business taxes, licences, and memberships
- Office expenses
- Office stationery and supplies
- Professional fees (including legal and accounting fees)
- Management and administration costs (or fees, if outsourcing)
- Rent
- Repairs and maintenance
- Salaries, wages, and benefits (including employer's contributions)
- Property taxes
- Travel expenses
- Utilities
- Fuel costs (except for motor vehicles)
- Delivery, freight, and express
- Motor vehicle expenses (not including CCA)
- Capital cost allowance (CCA)
- Any other expenses, to be specified on the space provided.
Subtract the total amount from the amount entered as gross business or professional income (line 8299 of Part 3C) or gross profit (line 8519 of Part 3D). Report the result on line 9369 of the T125 form.
Make the Final Adjustments
Take the amount entered on line 9369 of the T2125 form. Add the amount of the GST/HST rebate for partners that was received in the year. Subtract other amounts deductible from your share of the net partnership income. You can then subtract any business-use-of-home expenses. The result is your net income. Now all you need to figure out your profit margin is your revenue. What was that formula again? Profit Margin = (Net Income √∑ Revenue) x 100. We're on our way!
How Do You Calculate Revenue?
A simple way to find your revenue amount is to add up amounts from:
- Sales of goods and services
- Other operating revenue (such as rental revenue, fees, or commissions)
Source: Statistics Canada report, Financial Performance Indicators for Canadian Businesses (1998) infoentrepreneurs.com offers these things to consider to calculate revenue, as suggested by Canada Business Ontario. Some of these appear on the lists above, but they're good to keep in mind:
- Cost of goods sold (subtract the value of your year-end stock from its value at the beginning, and add the value of any purchases)
- Wages and salaries (including your own, at the rate you would pay someone else to do your job)
- Rent
- Utilities
- Cost of web presence (online stores, website hosting, domain name registration)
- Delivery expenses
- Insurance
- Advertising and promotional costs
- Maintenance
- Depreciation (a decline in the value of assets - it's important to know how much assets were worth when you used them)
- Taxes and licences
- Interest charges for money owed
- Bad debts (these are considered expenses because the debt cannot be collected)
- Professional assistance or special consultant fees (accountant, attorney, information technology specialist, etc.).
How is the Net Profit Margin Calculated?
The Business Development Bank of Canada uses a simple formula for its net profit margin calculator:
Net Profit Margin = (Net profit or income, after taxes √∑ Net sales) x 100
You can see how to determine net income above. The term "net" usually implies that whatever follows is an after-tax amount. The personal tax equivalent to net profit might be taxable income.
How to Calculate Net Sales
You need to find the figure that reflects your net sales to calculate net profit margin. To do that, figure out your gross sales, and subtract any returns, rejects (including damaged or missing goods) and applicable discounts. The result is your net sales. Gross sales numbers depend on whether you use the cash method or accrual method of accounting. With the cash method, include only sales for which payment has been received. With the accrual method, income and expenses are reported as they are incurred, regardless of whether payment has been received. Net sales are a key indicator of a company's profitability in the eyes of investors. Even if your business is privately owned, net sales numbers are a good way to measure your progress.
Net Profit Margin = (Net profit or income, after taxes √∑ Net sales) x 100
What is the Definition of Net Profit Margin?
Some refer to net profit margin as a business's bottom line since it reflects its profit after taxes. Net profit margin is also called the return on sales ratio.
Net profit margin shows exactly how much after-tax profit each sales dollar brings in. What percentage of your revenue does your business keep once all operating expenses, creditor interest, and income tax are paid? That's net profit margin. High net profit margins are thought to prove that a company is running well. If yours is higher than a competitor's, it could mean that your business is more efficient and adaptable. It's a way of situating yourself with regard to others in your industry. Even if you experience a decrease in net profit margin, remember to keep an eye on your peers. Perhaps the whole industry has been experiencing a decline. Maybe you're doing better than you think. While a strong net profit margin is a sign that a business is doing well, there are other factors to keep in mind. For example, investors may consider a business's liquidity as well.
Why are Key Financial Variables Important?
When you calculate your profit margin or net profit margin, you get a picture of the overall health of your business. Statistics Canada considers these and other figures when it seeks information about businesses and industries. Here are a few others from their list.
What is a Balance Sheet?
A balance sheet shows a business's total assets, liabilities, and equity.
- Total assets are the complete list of a business's economic resources. These may include: cash, accounts receivable, inventory, capital assets, etc.
- Liabilities are everything the business owes. This could mean accounts payable, income taxes payable, and borrowings.
- Equity is the accumulated undistributed earnings derived from all sources, including capital or extraordinary gains and losses.
What is an Income Statement?
An income statement includes revenues, expenses, gains and losses, income taxes, and various measures of profitability.
- Operating revenue: revenues from the sale of goods and services, rental revenue, commissions, franchise fees, royalties, etc.
- Operating expense: cost of goods and services used as inputs into production, wages and salaries, indirect taxes, machinery, natural resources, etc.
- Operating profit is the difference between operating revenues and operating expenses.
- Net profit, in this context, may use calculations that measure gains and losses for publicly traded companies, or that measure operating profit after taxes.
Reconciliation of Profit to Taxable Income and Taxes Payable
These figures show the necessary adjustments needed to compute taxable income and taxes payable.
- Taxable income (tax base) is the amount of income you have to pay tax on after the previous year's losses have been applied.
- Taxes include all federal and provincial taxes you have to pay according to the Income Tax Act.
What is Working Capital and How to Calculate It?
Working capital is the ratio between a business's current assets and its current liabilities. It shows how easily a business is able to pay short-term debts. The formula for working capital is:
Current assets √∑ Current liabilities
Calculating Receivable Turnover
Receivable turnover shows the quality and relative size of your accounts receivable. How often are accounts receivable converted into cash during the year? The formula to find receivable turnover is:
Sales of goods and services √∑ Accounts receivable
Finding your Place
The CRA encourages both new and existing businesses to consult its resources on Financial Performance Data. You can find information on over 1000 industries. Reports use various benchmarks to provide statistics for profitable and non-profitable small and medium-sized businesses. If you know about the other businesses in your field, you can build a better business plan. You can plan out your future with confidence when you know which financial factors will likely affect your business. Remember to keep accurate and complete records!
