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A net profit margin is a measure of profitability that provides an indicator as to how well a business is controlling costs and providing a return after all expenses are covered; net profit margin is also referred to as profit margin, net margin, and net profit ratio.
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Understanding Net Profit Margins
Net profit margins are actually a good way of comparing companies in the same industry because they are generally exposed to the same business and market conditions. It is also a good way of comparing industries to determine which is most profitable. In fact, the higher the net profit market margin, the less risky the industry or business is considered to be; in that a higher profit margin allows more room to give deeper discounts, absorb more costs, and still return a profit.
However, having a low profit margin doesn’t necessary mean that a company is having problems controlling its costs. In fact, certain industries may be low margin industries by their very nature; a good example is the discount retail industry. In other cases low profit margins may result from an ongoing price war between retailers, which is often short lived and will return to normal pricing levels after competitors concede defeat.
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How to Calculate Net Profit Margin
There are several variations of the net profit margin ratio formula; which one is used will depend on the objectives or preferences of the financial analyst. Here are the most common examples:
- Pretax Margin Ratio = net profit before taxes / sales.
- Net Profit Margin Ratio (After Tax Margin Ratio) = net profit after tax / sales.
- Operating Profit Margin (Operating Margin) = net income before interest and taxes / sales.
The different methods are necessary because companies and indeed industries, face different tax structures that can impact profitability. Using the respective variations acknowledges that taxation, by and large, is outside the control of business managers, and in fact, can change from one year to the next. Despite the variations, each method is a good measure of profitability, if applied consistently when analyzing companies and industries. Still, the most popular formula is the Net Profit Margin Ratio.
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Net Profit Margin Example
Here is an example of how to calculate a net profit margin of a company. Assuming that StarBooks sold 10,000 books at $10 each with a cost of goods sold of 40%, and tax and operating expenses totaling $5,000; what would be the net profit margin?
- Revenue = $100,000 (10,000 * $10)
- Cost of goods sold = ($40,000 ($100,000 * 40%)
- Net profit = $55,000 (100,000 - 40,000 – 5,000)
- Net profit margin = .55 or 55% (55,000/100,000)
It is important not to confuse markup with margin. A markup is the percentage of the cost price that is added to get to the selling price. On the other hand, margin is what percentage of the selling price is profit. Considering the example above, a 55% markup on $40,000 would result in a $22,000 profit as opposed to the net profit of $55,000. Therefore, a net profit margin of 55% is better than a markup of 55%.
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Net profit margins are a test of profitability that can be used to compare companies or industries. While in some cases it is a test of a company’s ability to control costs, it may also indicate that there is a price war going on or that an industry is highly competitive. To learn how to calculate profit margins simply divide net profit by revenue; whether or not tax is factored into the equation is a matter for the analyst to decide.
Image Credits - Dave Dugdale, http://www.rentvine.com/