In traditional accounting, a margin of safety is a measure of how a company or business will be able to “break even” in manufacturing products. This kind of cost accounting provides a basis for decision making by leadership. It deals with the projected cost of making a product versus potential revenues, where cost accounting is critical in helping to prevent financial mis-steps by planners.
The margin of safety uses an equation involving a break even point to help a company find out if it has made, or will make, a profit on a project. The use of this margin is more an analysis of cost of production, rather than any solid projection of actual revenues, since the equation doesn’t really fix a projected sales volume in most cases. Many companies make a visual representation of the safety margin in terms of a line or bar graph to help show whether the project is likely to generate profits.
Though the above represents the use of a margin of safety in accounting, the term is also getting used by investors after some prominent financial professionals have used it to describe research on company solvency in general. Some are using the term to describe favorable outcomes in doing due diligence on a company. Thus, this margin can thus be used to refer to how comfortable an investor might be with price to earnings ratios, or similar measures of future profitability for a business.
In general, a margin of safety helps establish “safe” guidelines for either investing or charting the future of a company. As this term starts to get used by more diverse types of financial professionals, it will come to define the appeal of a business in terms of profit. Beginners can read more on the use of this term from traders who provide books explaining the use of current terms related to the stock market and securities or equities trading.
When margins of safety are referred to as a “strength of business” analysis, it may also be part of SWOT analysis. SWOT stands for the strengths, weaknesses, opportunities and threats involved in some business ventures. This kind of analysis has been applied to Fortune 500 companies for several decades, and helps leaders to establish what challenges they are facing, and what opportunities they can take advantage of in their respective markets and industries.
