Net profit margin is a ratio or percentage that indicates a company’s profitability. A high net profit margin means that a company is selling well while efficiently covering its costs, while a low net profit margin means that it is not selling well and/or is not able to have a cost-efficient operation. Net profit margin can also be negative, which means that a company is incurring losses.
It doesn’t mean, however, that net profit margin should be interpreted using a 0 to 100 scale. Instead, it is dependent on various factors, such as a company’s location, industry, and the overall status of an economy. For instance, a 2% net profit margin for a sweet potato farm business can be considered high, and a 15% net profit margin for a photography studio can be low!
Read more: Why Is the Net Profit Margin Important
Net Profit Margin Equation
To get a better idea of how and why net profit margin is such a strong indicator of a company’s success, we need to look at the two values that affect it.
First is the revenue. This is the total amount of money that a company has made within a certain period of time. Next is the net profit. This is how much the company has earned after all expenses and costs have been subtracted.
The net profit margin is calculated using these two values that can be found at the end of an income statement: the revenue at the top line, and the net profit at the bottom line. Its formula is as follows:
Net profit margin = Net profit / Revenue x 100
Let us now take an example. Suppose we have company A with a total revenue of £30,000 and a net profit of £3,000. Following the formula above, we get this equation:
3,000 / 30,000 = 0.1
0.1 x 100 = 10
Therefore, Company A’s net profit margin is 10%. This means that for every £100 that it sells, it earns £10 in profit, while the £90 is spent in operating costs such as salaries, utilities, office supplies, and advertising.
Read more: How Do You Calculate Net Profit Margin
Net Profit Margin Interpretation
Aside from being a very telling figure of a company’s cost efficiency, the net profit margin can be used to read into a company’s current status, how it can grow better, and how it can compete more.
- In company. Company owners and managers use the net profit margin to measure improvement in cost efficiency and/or sales. Since it is derived from the net profit and the revenue, values readily available in a regularly released income statement, one can easily access and keep track of its movement. Net profit margin can be monitored annually, quarterly, or monthly.
- Against competitors. If placed side by side with the net profit margins of companies in the same industry, with the same company size, and in the same location, the net profit margin is an effective indicator of performance. Investors assess risks using this value. A company with a high net profit margin will attract more investors, which would translate to growth and, naturally, an even higher net profit margin.
- Against industries. For a person looking for the next big thing, net profit margin is a crucial value. Is agriculture a booming industry? Will launching an events venue be profitable? These questions can be answered with the help of the average net profit margins in various industries. Which ones are on the rise, which are declining, which ones are steady?
Net Profit Margin Improvement
A healthy net profit margin value can be achieved by focusing on the following:
- Reducing expenses. A company can look into their expenses and cut back on counterproductive costs. These may include laying off employees, suspending research & development, or discontinuing unprofitable product lines.
- Improving bargaining. This is especially helpful to companies who are in the business of producing goods to sell. Bargaining with suppliers for lower price of materials or goods would lessen the capital cost, which would increase the revenue. Assuming that expenses are the same, this will result in a higher net profit margin.
- Altering prices. Increasing the price of a product would not automatically translate to a higher net profit margin. Sometimes, lowering prices can be more profitable, as it potentially increases the unit sales of a product. There might be a magic number that would boost a company’s total sales, so it’s important to always stay afloat in pricing.
- Increasing sales. There are a lot of ways to boost sales such as boosting advertising, and increasing distribution channels.
Net Profit versus Net Profit Margin
While net profit is also a useful value in measuring a company’s success or failure, it falls short in the analysis of a company’s profitability compared to competitors.
Based on the above example, if Company A acquires £30,000 in a month in revenue, and then uses £27,000 in expenses, it gets to keep the remaining £3,000 in net profit.
This may be higher compared to say, Company B’s £2,000, but it doesn’t immediately mean that Company A is performing better. This is where net profit margin will prove to be useful. Let us now assume that Company A and Company B are in the same industry, in the same region, and have the same company size. If Company B’s revenue is £10,000 and it got to keep £2,000 in net profit, it means that it spent only £8,000.
Using the net profit margin formula, we get this equation:
8,000 / 10,000 = 0.2
0.2 x 100 = 20%
This means that Company B’s net profit margin is higher at 20% than Company A’s 10%. For every £100 that it sells, it gets to keep in earnings £20 – double the amount of Company A’s £10.
The ultimate goal is to have a high and increasing net profit margin. A company’s approach to business should always be forward and up instead of simply surviving. Ensuring that income statements are updated can be assured of an easily accessible and accurate net profit margin that can be used to make developments that would propel a company to unshakeable success.
One way to manage your finances is through the professional services of an accounting firm. Annette Ferguson – Chartered Accountant and Certified Profit First Professional – can help you unlock financial strategies to improve the profitability of your business amidst an economic crisis. Book a call with us. You can also follow us on any of our social media channels and subscribe to our YouTube channel.