In our latest article looking at key financial ratios we look at the net profit margin, providing you with analysis and an online calculator to see how it works.
Net Profit Margin is one of the most widely used ratios by investors and analysts. It is used in order to understand the ability that a company has to translate the revenue generated into profits that can be distributed to the investors after all expenses incurred during the year.
Net Profit Margin Formula
The formula for the net profit margin is : Net Profit / Revenue and expressed as a percentage. As an example, if ABC Ltd has a $200,000 net profit and $2,000,000 in operating revenue, then the net profit margin will be 10%.
A more detailed analysis of the above example is as follows:
Let’s assume that Company Z has published the latest income statement (or profit and loss account) which is as follows:
|Cost of Sales||$(1,200,000)||$(850,000)|
|Profit Before Tax||$500,000||$500,000|
|Profit After Tax||$400,000||$400,000|
The example above shows that while the profit after tax (which is also the total profit that is available for distribution to shareholders) remained stable during these two years, the net profit margin decreased.
Calculating the net profit margin for these two years gives:
20XX: Net profit Margin = (400,000/2,000,000)%= 20%
20XY: Net Profit Margin = ($400,000/1,500,000)%=27%
It is clear from the above example that while revenue increased during the second year, the net profit and therefore the net profit margin decreased. Net Profit Margin effectively shows if a company is able to control it’s costs in order to translate the revenue generated into distributable profits.
Therefore, while revenue is very important, so are the costs and not only the cost of sales but also the administrative expenses and the finance costs.
Net Profit Margin is one of the most widely used ratios by both analysts and investors. However, judgement should be exercised when comparing two potential investments or when comparing and judging the performance of two companies that operate in different industries.
As an example, companies that operate in competitive markets often try to grab additional market share by reducing their prices, at least for the short term. In addition, new companies might have increased interest expenses due to capital raised which should cause the net profit margin to decrease.
At the same time, increased net profit margin does not necessarily mean increased distributions since companies might choose to retain the profits.
It’s not that uncommon for a company to have one or more exceptional items on the income statement. As an example, an exceptional item might be an impairment, a restructure expense or a decommission cost.
Therefore, it might be useful to omit these exceptional items in order to maintain comparability.
Net Profit Margin vs Gross Profit Margin
Both net profit margin and gross profit margin are very useful and widely used ratios. However, there are quite different. Analyzing a company by calculating and using the gross profit margin, we effectively try to understand if the company is able to increase costs while controlling the costs that can be directly attributed to the manufacturing the delivery of a product.
However, the net profit margin allows us to see the bigger picture by incorporating not only the cost of sales but also other expenses such as payroll, other admin expenses, finance costs and the taxes paid.
At the same time, while net profit margin includes more costs, it also includes more costs that are subject to judgement and can therefore change from company to company. As an example, depreciation policy varies from company to company and net profit margin can be subject to costs that could be described as more judgemental.
Net Profit Margin online Calculator
The calculator below can be used to find the net profit margin of a company. Simply enter the net profit and the revenue in the boxes!