Margin of safety ratio

Margin of safety ratio refers to the amount of actual / the sales amount of expected ratio, also refer to the amount of actual Margin of safety or expected sales ratio, which is a relative quantity, used to evaluate the safety of different enterprises operating

1.Formula of Margin of Safety:

The formula or equation for the calculation of margin of safety is as follows:

[Margin of Safety = Total budgeted or actual sales − Break even sales]

The margin of safety can also be expressed in percentage form. This percentage is obtained by dividing the margin of safety in dollar terms by total sales. Following equation is used for this purpose.

[Margin of Safety = Margin of safety in dollars / Total budgeted or actual sales]

2.Solution to Review Problem:

Margin of safety = Total sales – Break even sales*

= $1,200,000 – $960,000

= $240,000

Margin of safety percentage = Margin of safety in dollars / Total sales

= $240,000 / $1,200,000

= 20%

*The break even sales have been calculated as follows:

Sales = Variable expenses + Fixed expenses + Profit

$60Q = $45Q + $240,000 + $0**

$15Q = $240,000

Q = $240,000 / $15 per unit

Q = 16,000 units; or at $60 per unit. $960,000

3.Investopedia explains Margin Of Safety

Margin of safety is a concept used in many areas of life, not just finance. For example, consider engineers building a bridge that must support 100 tons of traffic. Would the bridge be built to handle exactly 100 tons? Probably not. It would be much more prudent to build the bridge to handle, say, 130 tons, to ensure that the bridge will not collapse under a heavy load. The same can be done with securities. If you feel that a stock is worth $10, buying it at $7.50 will give you a margin of safety in case your analysis turns out to be incorrect and the stock is really only worth $9.

There is no universal standard to determine how wide the “margin” in margin of safety should be. Each investor must come up with his or her own methodology.