Margin of safety is a financial ratio measuring the amount of expected profitability that exceeds the breakeven point. In other words, it reveals the gap between estimated sales output and the level of sales that would make the company unprofitable.
The margin of safety ratio gives a company an idea of how much “breathing room” it has with its sales output. A higher margin of safety means the company has more protection from a decline in sales. It acts as a buffer so that volatile sales periods are not detrimental to the business.
A low margin of safety indicates the company does not have a wide buffer and needs to make some changes. This can be done by creating a more profitable product line, reducing variable costs, increasing sales volume, increasing the selling price, and more.
What is the margin of safety formula?
Margin of safety is typically expressed as a percentage. You can calculate the margin of safety by taking the current sales level and subtracting the breakeven point, then dividing by current sales level. The formula is:
Margin of safety = (current sales level - breakeven point) / current sales level x 100
If you prefer not to use percentages, margin of safety can be expressed in number of units or dollar amounts. The formula for margin of safety expressed in number of units is:
Margin of safety (# of units) = current sales units - breakeven point
To express it in dollar amounts, the following formula can be used:
Margin of safety ($) = current sales - breakeven sales
Margin of safety calculation example
A small company that provides house cleaning services has a current sales revenue of $165,000, and it calculates a breakeven point of $152,000. Simply plug these two variables into the formula to calculate a margin of safety of 7.88%.
(165,000 - 152,000) / 165,000 x 100 = 7.88%
What else is margin of safety used for?
In the investing world, margin of safety is the difference between a security’s intrinsic value and its market price. Having a large margin of safety protects investors from downside risk because it means the security’s price is well below what it’s worth. Since intrinsic value is an estimation calculated in different ways, margin of safety from an investment standpoint can vary.
Margin of safety is a tool used by deep value investors looking for significantly undervalued businesses. These types of investors are looking for stocks that have a large difference between intrinsic value and current price. They invest in companies with a high margin of safety and steer clear of those that don’t.
In accounting terms, margin of safety is the difference between profitability and breakeven point. A larger margin of safety indicates that a company has a greater buffer before becoming unprofitable, and a smaller margin of safety means the opposite.
Margin of safety is calculated as a percentage by subtracting the breakeven point from the current sales level and dividing by the current sales level. It can also be expressed in number of units or dollar amount. Margin of safety is also used in the investment realm to indicate the difference between a security’s market price and intrinsic value.
