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. We typically use it to understand a company’s ability to translate the revenue into profits that investors can then receive in dividends. So the control of costs to convert revenue into profits is critical in this margin calculation.
Net Profit Margin Formula
The formula for the net profit margin is (expressed as a percentage):
Net Profit / Revenue
For example, if ABC Ltd has a $200,000 net profit and $2,000,000 in operating revenue, the net profit margin will be 10 per cent.
Now, let us move onto an example with more detail. Company XYZ has published its latest income statement (or profit and loss account), which is as follows:
20XY | 20XX | |
| Revenue | $2,000,000 | $1,500,000 |
| Cost of Sales | $(1,200,000) | $(850,000) |
| Gross Profit | $800,000 | $650,000 |
| Admin Expenses | $(300,000) | $(150,000) |
| Profit Before Tax | $500,000 | $500,000 |
| Tax | $(100,000) | $(100,000) |
| Profit After Tax | $400,000 | $400,000 |
Analysis
The example above shows that while the profit after tax (the total profit 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 can control its costs to translate the revenue generated into distributable profits.
Therefore, while revenue is significant, so are the costs and the cost of sales, administrative expenses, and finance costs.
Comparison
Net Profit Margin is one of the most widely used ratios by both analysts and investors. However, you must exercise judgment when comparing two potential investments or when comparing and judging the performance of two companies that operate in different industries.
For 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, an increased net profit margin does not necessarily mean increased distributions since companies might choose to retain the profits.
Exceptional Items
It’s not uncommon for a company to have one or more exceptional items on the income statement. For example, an exceptional item might be an impairment, a restructuring expense, or a decommissioning cost.
Therefore, it might be helpful to omit these exceptional items to maintain comparability.
Net Profit Margin vs Gross Profit Margin
Both net profit margin and gross profit margin are beneficial and widely used ratios. However, there are quite different. Analysing a company by calculating and using the gross profit margin, we try to understand if the company can 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 the cost of sales and 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 has more costs that are subject to judgement and can therefore change from company to company. For example, depreciation policy varies from company to company, and net profit margin can be subject to costs that you could describe as more judgemental.
Net Profit Margin Online Calculator
You can use the calculator below to find the net profit margin of a company. Enter the net profit and the revenue in the boxes.