The net profit margin is a profitability ratio that expresses the profit from business operations as a percentage of revenue or net sales. It accounts for all expenses a business faces, not just the cost of goods sold.
Here's how to calculate it, how analysts use the ratio, and some scenarios in which the effectiveness of the ratio might break down.
What Is Net Profit Margin?
The net profit margin is a ratio that compares a company's profits to the total amount of money it brings in. It measures how effectively a company operates. If a company has a 20% net profit margin, for example, that means that it keeps $0.20 for every $1 in sales revenue.
This ratio is used to give analysts a sense of a company's financial stability. Companies that generate greater profit per dollar of sales are more efficient. That efficiency makes a company more likely to survive when a product line doesn't meet expectations, or when a period of economic contraction hits the broader economy.
Note
The three main financial statements are the balance sheet, income statement, and statement of cash flows. The income statement is used to gather the information needed for the net profit margin.
How Do You Calculate Net Profit Margin?
The net profit margin is calculated by dividing net profits by net sales. To turn the answer into a percentage, multiply it by 100. Some analysts may use revenue instead of net sales—either will give you a similar answer, the net sales figure is just a bit more specific.
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How Net Profit Margin Works
Before you can calculate the net profit margin, you'll have to calculate net profit and net sales.
Net profit is calculated by subtracting all of your expenses from your revenues. These include wages, salaries, utilities, and other expenses.
You can calculate net sales by subtracting your allowances, returns, and discounts from your total revenue. Allowances are problems with a product or service that results in a price reduction to satisfy the customer. A return is any refund for a product or service.
Interpreting Your Net Profit Margin
The net profit margin can indicate how well the company converts its sales into profits. In other words, the percentage calculated by the net profit margin equation is the percentage of your revenues that are profits that the company gets to keep.
Conversely, this ratio also indicates the amount of revenue you are losing through costs and expenses associated with your business. It can help analysts figure out whether a business should focus on whittling back spending.
Both net sales and net income are related to each other, in that expenses can increase prices and decrease sales (depending on your product and audience). It may not always be easy to determine the exact relationship.
For example, increasing expenses to produce a higher quality product could attract enough customers to increase net sales. On the other hand, an increase in expenses could also decrease net sales if too many of those expenses are passed onto the customers in the form of higher prices. If customers decide the price hike isn't worth the higher quality product, revenue will fall.
Limitations of Net Profit Margin
Debt financing—borrowing money to finance your operations—can reduce your net profit margin. If you decide to use debt financing for your business, you would see an increase in interest expenses, which could skew your net profit margin toward an undesirable level.
However, that doesn't necessarily mean that debt financing was the wrong move for you to make. Determining the quality of the net profit margin in scenarios like these often requires a deeper analysis of why the debt was acquired, how it will be used, and whether the debt-to-asset ratio is healthy.
The net profit margin can be used to effectively compare performance over different periods. However, this only reveals reliable results if nothing else has changed in your expenses.
Note
The more you change your expenses, the less reliable the net profit margin becomes for comparing historical performance.
As you continue to analyze your business's financial results and performance, you may make adjustments in expenditures over time. Be aware that, as you do this, it decreases the comparability of this measurement over multiple periods.
Key Takeaways
- The net profit margin is a ratio formula that compares a business's profits to its total expenses.
- The net profit margin allows analysts to gauge how effectively a company operates.
- The higher the net profit margin, the more money a company keeps.
- Comparing net profit to net sales will give you the most accurate results possible, but revenue can be used in place of net sales.
