How to calculate Net Profit Margin
Net Profit Margin = ( Net Profit / Revenue ) x 100
Net profit margin is computed by dividing the net profit by the revenue, and then multiplying it by 100.
It is a percentage that indicates a company’s profitability.
A 20% net profit margin means that for every pound in revenue, there is a £0.20 in net profit.
The higher the net profit margin, the better.
It is an important value that is indicative of a company’s health and profitability. It is not only helpful to a company seeking growth and success, but also to investors. Banks also use it to evaluate a company’s ability to sustain a loan by looking at its net profit margin.
As mentioned, the formula for net profit margin is:
( Net Profit / Total Revenue ) x 100 = Net Profit Margin
And it's important to note that if a business is VAT registered these number are excluding VAT (which is how the profit and loss account is presented - so you can take your numbers from your profit and loss account).
To understand it better, let’s take an example.
|Toy Shop A Income Statement (aka Profit and Loss Account)|
|Cost of Goods||(30,000)|
Based on this Income Statement (or Profit and Loss Account), the equation will be:
70,000 / 200,000
= 0.35 x 100
Therefore, Toy Shop A’s net profit margin is 35%.
Understanding the results
Arriving at a value is only the beginning of understanding net profit margin.
Whether a 35% net profit margin can be considered high or low isn’t reliant on a universal number chart.
Let’s take Toy Shop A above as an example, and compare it with Toy Shop B with the following numbers:
Total Revenue: 250,000
Total Expenses: 170,000
Total Net Profit: 80,000
Following the above formula, we get this equation:
( 80,000 / 250,000 ) x 100= 32%
Toy Shop A’s net profit margin is higher (35%) than Toy Shop B’s (32%), even though its net profit is lower at 70,000 compared to 80,000.
Moreover, interpreting net profit margin should factor in other relevant data and information, such as the following:
- Industry type. Depending on the industry, average net profit margin can be as low as 5% and can go as high as 20%.
- Industry trends. Looking at competitors’ net profit margin and seeing a consistency may be attributed to factors that affect an industry as a whole.
- Company’s historical values. Ideally, a company’s net profit margin should always be on the increase.
- Competitors’ net profit margins. Simply put, a higher net profit margin than one’s competitors means better performance.
You might also be interested in: How to double your net profit margin
Limitations of Net Profit Margin calculations
While net profit margin is an important value to any company, it also has its limitations, especially when using it for internal company decisions.
For instance, the operating margin is a better value to look at when a company wants to see its operating profitability. This value takes out the interest and tax, while the net profit margin considers these values.
Another instance when the net profit margin can be deceiving is when a company has one-time expenses that may take up a huge chunk of its net profit, such as a one-time payment for a lawsuit. For the purpose of looking into a company’s operating profitability, the adjusted net profit serves as a better measure, as it takes away such expenses.
That said, it’s important to note that the net profit margin is an accounting profit instead of a cash profit.
Nonetheless, it serves as a highly valuable metric that every company should monitor on a regular basis with the help of a credible accounting firm.