Explanation & Examples of Net Profit Margin Ratio

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Profitability is an important measure of how well a business is being run and by extension how well it is doing in the market place, which makes the net profit figure a very important figure, as far as investments and management are concerned. As a matter of fact, net profit may very well be the most import factor to consider when comparing companies and industries. To ensure that companies are fairly compared, in terms of profitability, the net profit margin ratio is often used.

A net profit margin measures the ratio of profit to revenue earned, in other words how much profit does a company make for every dollar it earns in revenue. The formula for calculating net profit margin is to divide Net Income by Revenue. That is, after taking into account the cost of sales, administration costs, selling and distributions costs, and sometimes taxes and interest expenses.

How to Calculate Net Profit Margin

However, there are variations of the formula that are often used by analysts and managers, particularly where there is a need to determine what the net margin would be if there was no taxation and interest payment to make. The variations of the formula are important especially since companies face different tax structures and financial obligations. In such cases it is necessary to add interest and taxation charges back to the net profit figure, or simply use the “Profit before Interest and Taxation” number.

Lets look at an example. Assuming that XYZ generates sales of $100,000 with cost of goods sold of $40,000, what would the net profit margin be if XYZ has administrative expenses of $10,000, taxes charges of $5,000 and interest expenses of $2,000?

First, let us calculate the profitability figures:

Gross profit = sales – cost of good sold
$100,000 – $40,000 = $60,000
Net profit = Gross profit – expenses- taxation -interest
$60,000 - $10,000 - $5,000 - $2,000 = $43,000

Depending on the net profit margin method that is being used, the net profit margin is calculated as follows:

(net profit/sales)*100
(43,000/100,000)*100
43% or 40cents on every dollar

Or,

(net profit before interest and taxation/sales)*100
60,000 - 10,000 = 50,000
(50,000/100,000)*100
50% or 50cents on every dollar

These are pretty high figures, which would suggest that either the company has a very high quality product that customers are prepared to pay a premium for; there is little competition or XYZ is doing an outstanding job of controlling costs.

Conclusion

Net profit margin determines just how much of sales/revenue actually remains in the company as net profit, which is a good measure of how well a company is controlling its costs as well as giving some indication of the competitive environment that the business operates in.

Whether the ratio is calculated using net profit before interest and taxation is a matter of preference of the analyst as well as being a necessary adjustment when comparing companies that fall under different tax brackets or enjoy the benefits of varied financing arrangements.

Image Credit: “Net profit margin ratio.” Greg Dugdale