Net Profit Margin – Meaning, Calculation, Limitations, And More

The biggest challenge for any company is to generate substantial income while managing costs and expenses. While very few manage to sustain themselves in the long run, most businesses simply break even with their expenses. Net profit margin can give a good insight into a company’s profitability against its revenue. 

Thus, it is vital to track a company’s net profit margin to clarify what measures need to be taken to grow the business. Let’s read more on net profit margin.

What is the net profit margin?

Net profit margin, also known as net income margin or profit margin, is a ratio used to calculate the percentage of profit businesses generate from their total revenue. Simply put, net profit margin calculates how much money a company retains from its sales or revenue.

Tracking the net profit margin is essential to understand how profitable the business is and how expenses can be managed. 

A high net profit margin indicates the company has good financial health.

It is important to note that the net profit margin could fluctuate from one business to another, depending on the sector, scale, and many other factors. However, that does not indicate that a business is less profitable than another. 

• Net profit margin is the percentage of revenue a company retains after deducting all the expenses. 
• Monitoring the rise and fall of a company’s net profit margin ratio can help predict future profits.
• A higher net profit margin indicates that a company is financially healthy and can effectively manage expenses. A low ratio can be a negative sign. 

How to calculate net profit margin?

Net profit margin depicts what percentage of total income is the profit.  

Net profit margin formula 

Here is the formula to calculate the net profit margin –

Net profit margin = Net income/ Total revenue X 100

The total revenue or total sales comprise all the earnings a company has generated via operations in a stipulated period. Likewise, net income refers to all the earnings left with a company after the expenses have been deducted. 

To use the net profit margin formula, you must first identify how to calculate net profit. Below, find the formula for calculating net profit:

Net profit = Total revenue – Cost of Goods Sold (COGS)  – Operating Expenses – Depreciation and Amortisation – Interest – Taxes

To understand the application of the net profit margin formula, refer to the example below. 

Example of net profit margin

For instance, assume Company ABC generates Rs. 1,00,000 through sales. However, the cost to produce the goods was Rs. 40,000. Company ABC has operating costs of Rs. 5,000, 5,000 depreciation, 2,500 interest and 2,500 taxes. Then, you can implement the net profit margin formula in the following manner:

Net profit margin = 1,00,000 – 40,000 – 5,000 – 5,000 – 2,500 – 2,500 / 1,00,000

Net Profit Margin = 0.45 X 100 = 45% 

You can see the net profit margin of Company ABC is 45%. This means 45% of their total sales is profit.  

Understanding the net profit margin ratio

The net profit margin ratio is an excellent indicator of how much profit a company has been making from its revenue. Additionally, if employed rightfully, the net profit margin ratio can help companies cut down expenses and keep them in control. 

How to analyse a company using net profit margin?

The net profit margin depicts how a company converts its sales into profits. Simply put, the percentage measured by the net profit margin equation is the proportion of revenues, which are profits. Additionally, this ratio indicates the portion of the revenue a company is losing due to expenses and related costs. In that sense, the ratio can give investors a fair idea of profit, revenue and expenses.

Both net income and net sales are directly associated with each other. For instance, increasing expenses to create a higher-quality product may increase sales. Conversely, a rise in expenses can also increase net sales if those expenses are accounted for through high prices. The downfall is that if the customers decide the product and its quality is not worth the premium price, it can severely hamper the revenue. 

A company’s net profit margin is best analysed holistically. Investors must study every component of the ratio deeply to understand a company’s standing –Why has the company registered more sales in a particular quarter? Why are the expenses increasing or decreasing? Is the net revenue growth healthy? All such questions must be pondered upon. 

Remember, the net profit margin ratio is used to determine a company’s profits, but it should not be the only financial metric to identify profitability, as it can be inflated or manipulated. 

What are the limitations of net profit margin?

1. Comparing companies

Companies belonging to different industries are likely to have completely different business models. For example, a high-end jewellery brand that sells various accessories can churn higher profit margins compared to a supermarket featuring multiple budget-friendly products. As such, comparing companies from different industries can result in a skewed evaluation. 

2. Profit manipulation

It is highly possible that midsize or small businesses may choose to cut down or not report long-term expenses by eliminating elements like rent or accounting to show high profits. Now, this’ profit manipulation’ or ‘income smoothing’ can misguide potential investors and make the net profit margin seem healthy.

What is a good net profit margin? 

The net profit margin would vary from industry to industry and the scale of the business. 

But as a general rule of thumb, a 20% margin is considered good (or high), a 10% margin is considered average, and a 5% margin is considered low. 

Conclusion

Net profit margin is an important financial metric used by investors and analysts to evaluate a company’s profitability. It is a simple calculation that indicates what amount of earnings turn up as profits. This calculation is done at the end of each year to determine the amount of money directed towards the profit and the expense. However, it has its own limitations, so use the ratio and other metrics to understand a company’s standing thoroughly.

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