Margin of safety is a cost accounting measure that helps companies determine if they will make a profit on a project. It can also be used by investors to analyze a company’s solvency and future profitability. It is often used in SWOT analysis to determine a company’s strengths, weaknesses, opportunities, and threats.
In traditional accounting, a margin of safety is a measure of how well a company or business will be able to “break even” in manufacturing products. This type of cost accounting provides a basis for leadership decision making. It deals with the projected cost of making a product versus potential revenue, where cost accounting is critical to help prevent financial errors by planners.
The margin of safety uses an equation involving a break-even point to help a company discover whether it has made or will make a profit on a project. The use of this margin is more of a cost of production analysis, rather than a solid projection of actual revenue, as the equation does not really fix a projected sales volume in most cases. Many companies make a visual representation of the margin of safety in terms of a line or bar graph to help show whether the project is likely to generate profit.
Although the above represents the use of a margin of safety in accounting, the term is also used by investors after some prominent financial professionals have used it to describe research into the solvency of the company in general. Some are using the term to describe favorable results from doing due diligence on a company. Therefore, this margin can be used to refer to how comfortable an investor can be with price/earnings ratios, or similar measures of future profitability for a business.
In general, a margin of safety helps establish “safe” guidelines for investing or charting the future of a company. As this term begins to be used by more diverse types of financial professionals, the attractiveness of a company in terms of earnings will be defined. Beginners can read more about the use of this term from traders who provide books that explain the use of current terms related to the stock market and stock or stock trading.
When margins of safety are referred to as a “business strength” analysis, it can also be part of the SWOT analysis. SWOT represents the strengths, weaknesses, opportunities and threats involved in some business ventures. This type of analysis has been applied to Fortune 500 companies for several decades and helps leaders determine what challenges they face and what opportunities they can take advantage of in their respective markets and industries.
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