Margin
Encyclopedia of Business Terms and Methods, ISBN 978-1-929500-10-9. Copyright © 2011 by Marty J.Schmidt.Revised 13 January 2012.
The Meanings of Margin in Business, Finance, and Investing
The term margin is used in business, finance, and investing in at least three different ways:
- As an investment term, margin refers to buying shares of stock or other securities with a combination of the investor's own funds and borrowed funds. If the stock price changes between its purchase and sale, the result for the investor is leverage: the investor's percentage gain or loss is magnified, compared to the percentage gain or loss had the investor purchased shares without borrowing.
- As a general term in business and commerce, the term margin refers to the difference between selling price and the seller's costs for the goods or services being sold. Margin includes only the seller's direct cost for the item or services, but not the costs of selling them (such as store leasing fees or marketing costs), and not business overhead costs (such as computer systems for the business or management salaries).
- In financial accounting, margin refers to three specific income statement results: gross margin, operating margin, and profit margin. Analysts and management look to these margins as measures of the company's earning performance.
Margin, in both senses, is defined and illustrated in the context of related concepts in the sections below:
• Margin: Investing with Borrowed Funds
– Margin Example: Stock Price Rises and Investor Gain Increases
– Margin Example: Stock Price Falls and Investor Loss Increases
• Margin as Profit
– Margin from the Seller's Viewpoint
– Margins as Income Statement Profits
– Three Kinds of Margins (Three Kinds of Profits)
• Sample Income Statement
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Margin: Investing with Borrowed Funds
Investors who buy shares of stock or other securities partly with their own funds, and partly with funds borrowed from the broker, are buying on margin. Buying on margin provides leverage, that is, an opportunity to magnify investor gains from given size if the stock price rises. At the same time, buying on margin increases investment risk, because the investor's losses also increase if the stock price if the stock price falls.
Margin Example: Stock Price Rises and Investor Gain Increases
The table below illustrates how the investor gains by investing $1,000 of his or her own funds, when the stock price rises. The gain is shown both with margin buying allowed (middle column) and without (right column).
| INVESTOR LEVERAGE | With 50% Margin | Without Margin |
|---|---|---|
| Initial stock share price | $10 / share | $10 / Share |
Funds Available for Purchase | $1,000 $1,000 $2,000 | $1,000 $ 0 $1,000 |
| Shares purchased | 200 | 100 |
| Stock share price with 30% price rise | $13 / share | $13 / share |
| Sale of stock after price rise | $2,600 | $1,300 |
| Interest charges on margin loan | $50 | $0 |
| Investor's funds after interest and repaying margin loan | $1,550 | $1,300 |
| Investor's net gain/(loss) on $1000 investment | $550 or 55% | $300 or 30% |
Margin Example: Stock Price Falls and Investor Loss Increases
The table below uses the same buying situation to show how the investor loses by investing $1,000 of his or her own funds, when the stock price falls. The loss is shown both with margin buying allowed (middle column) and without (right column).
| INVESTOR LEVERAGE | With 50% Margin | Without Margin |
|---|---|---|
| Initial stock share price | $10 / share | $10 / Share |
Funds Available for Purchase | $1,000 $1,000 $2,000 | $1,000 $ 0 $1,000 |
| Shares purchased | 200 | 100 |
| Stock share price after 30% price drop | $ 7 / share | $ 7 / share |
| Sale of stock after price drop | $1,400 | $700 |
| Interest charges on margin loan | $50 | $0 |
| Investor's funds after interest and repaying margin loan | $350 | $700 |
| Investor's net gain/(loss) on $1000 investment | ($650) or -65% | ($300) or -30% |
When stock price falls, moreover, the broker may send a margin call to the investor, requiring that the investor contribute funds to restore the original equity (ownership) balance in the position.
Remember that the broker had originally contributed 50% towards the purchase, and was owed 50% of the stock value. After the price drop in the example above, for instance, when the stock price fell 30% to $7 per share, the 200 shares had a market value of $1,400. However, the broker had still loaned $1000, to the investor, which is now considered an equity position of about $71% of the current total stock value. In order to bring the broker's stake in the investment back down to the original 50% level, the investor will need to pay the margin call (or repay, that is, part of the margin loan) of about $300, to restore the brokers equity stake to 50%.
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Margin as Profit
Margin from the Seller's Viewpoint
Sellers (vendors) generally refer to margin as the difference between their cost for an item and the selling price. An item for which they pay $60 to their supplier, but which they sell for $100, has in this sense a $40 margin.
Margin in this sense refers to margin on the item, but does not include the seller's overhead costs for such things as store leasing fees, nor does it include general overhead costs for such things as management salaries. Here, the term margin is very close in meaning to what accountants call gross margin (see following sections).
Sellers, large and small, have a keen interest in knowing their margin on individual products. On the one hand, they may be quite willing to sell low margin products if these are sold in high volume, or if they leverage sales of higher margin products. On the other hand, with lower volume sales or the absence of product-to-product leverage, they will want to concentrate selling resources on the higher margin products
Margin From Income Statement Profits
The term margin, when used in accounting and financial reporting, refers to any of three "profit" lines on the income statement. A margin, specifically, is a profit figure expressed as a percentage of the company's net sales revenues.
The income statement generally shows how income figures result by subtracting the entity’s costs and expenses from its total sales revenues.
Income = All Revenues - All expenses and costs
Note by the way, that reported income, revenues, and expenses do not necessarily represent real cash inflows or outflows. This is because regulatory groups, standards boards, and tax authorities, allow or require companies to use conventions such as depreciation expense, allocated costs, and accrual accounting on the income statement. Actual cash flow gains and losses for the period are reported more directly on another reporting instrument, the Statement of Changes in Financial Position (or cash flow statement).
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Three Kinds of Profits (Three Margins)
Bottom line net income on sales (net profits on sales) is a measure of the company's financial performance for the period, but the income statement contains other performance metrics as well. The difference between net sales revenues and cost of goods sold is called Gross profits, for instance, while the net income from operations—before taxes and before gains and losses from financial and extraordinary items—is called operating income (or operating profits).
All three of the profit lines from the income statement (gross profit, operating profit, and bottom line net profit) can also be expressed as a percentage of net sales, that is, as margins. Gross profit, for instance is gross profit divided by net sales (see the table below):
Margins, in turn, are very important profitability metrics, of keen interest to the company's management, employees, competitors, and shareholders. For more on margins as profitability metrics, along with other profitability metrics, see profitability.
Sample Income Statement
The profit margin examples above use data from the sample income statement below. See the encyclopedia entry Income statement for more on the structure and uses of the income statement itself. See the entry Profitability for more on profitability metrics, including Gross margin, Operating Margin, and Profit margin on sales. The spreadsheet tool Financial Metrics Pro also has more in depth coverage of these topics along with working examples, templates, and a complete system of interrelated metrics and financial statements.
Grande Corporation Gross sales revenues.................33,329 Gross profit.................................10,940 Operating expenses Operating income before taxes............... 3,130 Financial revenue & expenses Income before tax & extraordinary items..... 2,737 Extraordinary items Net Income (Profit).......................... 2,126 |
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