Net Profit Margin or Ratio

Net profit margin is one of the profitability ratios and an important tool for financial analysis. It is the final output, any business is looking out for. Net profit ratio is a ratio of net profits after taxes to the net sales of a firm. All the efforts and decision making in the business is to achieve a higher net profit margin with an increase in net profits.

Definition of Net Profit Margin

Net profit margin shows the margin left for the equity and preference shareholders i.e. the owners. Unlike the gross profit which measures the operating efficiency of the business, it measures the overall efficiency of the business. An adequate margin of net profits will be generated only when most of all the activities are being done efficiently. The activities may be production, administration, selling, financing, pricing, tax management or inventory management. Even if any of these perform badly, the effect on net profits and their margins can be seen.

For example, inventory management had some problem in a particular year and profit margins fell down. Net Profit Ratio or MarginThe management needs to focus on that part to regain the same ratios. One way of helping to ensure profit margins is to use a third-party logistics company to help manage inventory. Once the said problem is resolved, the company can again see the rise in their margins.

How to Calculate Net Profit Margin Ratio with Formula?

The formula for net profit margin is as follows:

Net Profit Margin Ratio = Net Profit / Net Sales

The calculation of net profit margin does involve too many calculations but deciding which profit to be taken for calculation is a concern. The different levels of profits can be

Profit before Interest and Taxes (PBIT)

There are many authors of financial management books who are in favor of using PBIT for the calculation of net profit margins because it nullifies the effect of modes of finance. This is particularly useful when the purpose of calculating net profit margin is to assess the operating efficiency of the business. With this profit, the ratio can be comparable to the industry and competitors.

Net Profit Ratio - Margin

Profit after Taxes (PAT)

This profit is the taken in the conventional way of calculating the ratio. The margin when calculated with PAT shows the effect of all the activities of the business considering that the financing of assets is not a separate activity but an important activity of the business.

Interpretation of Net Profit Margin / Net Margin / Net Profit Ratio

The percentage shown by net profit margin does not have any specific benchmark. It is because the net profit margin of a small business and big steel plant cannot be same and therefore a standard benchmark cannot be set. The interpretation is more meaningful when the data of more than one period are available or the industry or competitor’s net profit margins are available.

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Comparison with Past Periods

It is normally advisable to have improved net margins compared to the previous periods. If the margins are not improved, it calls for careful analysis to find out the reasons for the decline. Since the net margins are dependent on many factors starting from the cost of production till the taxes paid in a profit and loss account.

Comparison with Competitors or Industry

If the margins are not as good as the competitors have, it is sure that there is some deficiency in the business operations. With same industry and same economic conditions, two businesses should normally have same profit margins. A major negative deviation in the profit margins is a serious matter to be handled with extensive care. Since profits are the lifeblood of any business. Any compromise in profits may raise a question mark on the sustainability of the business.

Sanjay Bulaki Borad

Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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3 thoughts on “Net Profit Margin or Ratio”

  1. I was wondering what the downside of using the net profit ratio was. As in a weakness, such as it doesn’t take into consideration the cash flow that is entering the business but takes only the profit. I am doing this for a school project and could really use an insight.

    Reply
    • Hi Izzy,
      The weakness of Net Profit Margin as a Ratio is as follows:
      1. It ignores Cash Flow.
      2. It also ignores Absolute Figures in Terms of Dollars which are also equally relevant.
      3. It may be misleading when there are some non-operating revenues contributing heavily to the net profits.
      4. Just relying on this ratio standalone won’t make sense. There are 2 ways to make it effective – one, compare it with the industry average and two, look at the trend of the last 3 to 4 years.
      5. This ratio should be combined with other ratios like asset turnover ratio, gross margin, etc.
      Hope it helps you understand better.

      Reply

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