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 dollar in revenue, there is a $0.20 in clean 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.
The formula for computing for net profit margin is as follows:
Net Profit / Total Revenue = Net Profit Margin x 100
It basically calls for the two values at both ends of a financial statement: the revenue or the “top line”, and the net profit or the “bottom line”.
To understand it better, let’s take an example.
|Toy Store A Income Statement|
|Cost of Goods||(30,000)|
Based on this income statement, the equation will be:
70,000 / 200,000
= 0.35 x 100
Therefore, Toy Store A’s net profit margin is 35%.
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 Store A above as an example, and compare it with Toy Store 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 = 32%
Toy Store A’s net profit margin is higher (35%) than Toy Store 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. 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.
Read more: Why is The Net Profit Margin Important
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 shield, 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 with a proven track record.