How to Calculate Margin of Safety
Businesses need to monitor expenses, cash flow, and profit margins. Additionally, it’s also essential for businesses to keep track of the margin of safety to determine the soundness of the business.
The margin of safety, also called the MOS, has two applications.
In business, the margin of safety is the difference between actual sales and the breakeven point (BEP). The margin of safety can help accountants to determine how much sales can decrease before a company suffers a loss.
When the margin of safety is high, the odds of the company incurring a loss are low. Conversely, when it’s low, a decrease in sales may lead to loss or even insolvency.
A low margin of safety is usually a key concern for businesses. If accountants establish the margin of safety is low, the business may increase the selling price of products, increase the volume of production or reduce fixed and variable costs to improve the margin of safety.
Business aside, the margin of safety is also an investment principle. Investors who follow the principle only purchase securities when their market price is below their intrinsic value. The intrinsic value of a security is its anticipated or calculated value established through fundamental analysis.
Establishing a security’s intrinsic value is highly speculative because methods vary from investor to investor, and some methods may be inaccurate.
Overall, calculating margin of safety allows businesses and investors to incur a few losses, but it protects them from major losses.
In accounting, the margin of safety can be calculated by deducting the breakeven sales from actual sales. For example, if Company XYZ made $150,000 in sales with a breakeven point of $75,000, they would have the following margin of safety:
Actual sales $150,000
Breakeven point $75,000
The margin of safety $75,000
Alternatively, the margin of safety can also be expressed as a percentage. You can use the formula below to calculate the margin of safety:
Margin of safety = (Actual sales – Breakeven sales) / Actual sales x 100
The ideal safety margin isn’t a specific figure. It varies from business to business. However, as a rule of thumb, a high safety margin is better than a low one.
Importance of Margin of Safety
The margin of safety is important for several reasons. First, it helps businesses determine how far they are from being unprofitable, allowing them to take measures to prevent loss. Additionally, it can also guide businesses on how to manage inventory.
For example, a business can use the margin of safety to find out whether a product is selling or not. Meanwhile, the margin of safety can also help investors make sound investment decisions and protect them from financial loss. However, to the unacquainted investor, learning how to use the margin of safety can be challenging.
That’s where SoFi Invest comes in. SoFi Invest helps investors to trade in securities. Investors can learn how to apply the margin of safety to their trades on an intuitive platform.
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