Several investors, financial professionals, and accountants use net profit ratio to evaluate a company’s financial health. The net profit ratio helps investors to track how much profit a company is making from its sales. Furthermore, the ratio indicates whether operating costs and overhead costs are contained. Without further ado, let us explore the other important aspects of net profit ratio.

This article covers:

What is the net profitability ratio?

Net profitability ratio is used to measure the profitability and financial value of a company. This can be achieved by primarily taking into account the production and distribution costs of its products, in addition to other expenses. 

Calculating net profit ratios helps businesses find out if their ongoing business practices are helping them to generate extra revenue against their investment in production. 

Lastly, depending upon the net income, the net profit ratio can be negative or positive. A negative net margin indicates unprofitability and vice-versa. The rise and drop in the net profit ratio is not only a useful indicator to assess a company’s current financial status, but it can also help predict the company’s profits based on revenues.

What does the net profit ratio of a company signify?

The net profit evaluates the amount of net income/profit made against revenue in percentage form. It is called net profitability ratio because it measures the ratio of a company’s net profits to its revenue. 

It is one of the most important metrics that indicates a company’s overall financial health. By using the net profit ratio of a company, you can make comparisons between two or more companies (on the profit front) from the same industry, irrespective of their size.

How is net profit ratio calculated?

The net profit ratio formula is as below:

Net profit ratio = Net Profit/Income / Total Revenue/sales x 100

Net Profit calculations:

Company XCompany Y
Revenuea2002000
Operating expenseb1501500
Gross profit c = a-b50500
Interest +Depreciation and Amortizationd550
PBTe = c-d45450
Tax  (10%)f4.545
Net Profit g = e-f40.5405

Now here, the net profit ratio for companies X and Y would be as follows:

Company X = 40.5 / 200 x 100 = 20.25%
Company Y = 405/ 200 x 100 = 20. 25%

You can see clearly that despite Company Y being 10 times bigger than company X, the net profit ratio of both these companies is the same. They have varying costs on all fronts, from EBITDA to taxes, yet profits that both these companies earn remain the same. Investors would naturally favour a company that makes the same profit at a smaller cost.

Merits of net profit ratio

  • A net margin is a useful tool in measuring a company’s overall profitability. 
  • As net profit ratio is determined in percentage, it determines the amount of profit generated from every Rupee in sales while also considering all business expenses involved in earning those revenues. 
  • A high net profit ratio indicates that a company can effectively control its costs while also providing goods or services at a significantly higher price than its costs. 
  • With gross margin, you can understand the trends of an organization’s COGS and determine its profitability within the scope of production.
  • The net margin indicates a company’s efficiency for cost-containment measures over time.

Demerits of net profit ratio 

  • Companies may influence their net profit ratio by increasing the sale of one of their assets. By doing so, they can boost profits temporarily. In other words, they can be grossly misguiding.
  • By understanding the net profit ratio of a company, you cannot evaluate its management efficiency.
  • The net profit ratio significantly differs between companies of different industries. For instance, while comparing an automotive company with a food processing company, the automotive business may show a high-profit margin but lower revenue. In contrast, the food processing company may have a lower profit margin ratio but greater revenue. Experts, therefore, believe it is wiser to compare only companies from the same sector with similar business models.
  • While calculating profit margins, one may misinterpret the profit margin ratio and cash flow figures. For instance, a low net profit ratio does not necessarily determine a poorly performing company, and a high net profit ratio does not necessarily mean high cash flows.
  • Companies periodically publish their financial reports that state the net income as a separate item in the income statement. Financial experts believe it is wiser to consider different ratios and financial metrics for drawing a company’s analysis. It is ideal to use net profit ratio in a company’s financial analysis while also referring to gross profit margin and operating profit margin.

Conclusion

There are many profitability metrics available to an investor. Of all, net profit ratio is the most popular. It evaluates the amount of net profit a company makes against revenue in percentage form. Through public income statements, anybody can assess where a company stands. But, one should never rely just on one metric, ratio or tool to analyse a company’s position and profitability. A holistic approach will always keep an investor ahead in the fiercely competitive market.

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