Why Is Net Profit Margin Important?

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Net profit margin is important because it tells of a company’s performance – whether it is experiencing success or setbacks. It is a value in the form of a percentage that tells the ratio of a company’s net income to its revenue, derived from the net profit or the “bottom line” of a financial statement.

 

Based on net profit margin, a company can immediately assess if strategies rolled out are working as they should, if there are loopholes to look for and amend, and if future profit looks promising or not.

 

However, interpreting it is much more than simply googling “What is a high net profit margin?” and getting a specific number such as 15%. There are a lot of factors that would indicate if a company’s net profit margin is high or low, regardless of the value.

 

What is a High Net Profit Margin?

 

Let’s ask anyway. A higher percentage does not necessarily mean that a company is performing well. As mentioned above, there are a lot of details to factor in when it comes to interpreting net profit margin. A small business’s 17% net margin can mean poor performance compared to a 5% net profit margin of say, a huge corporation. How is this so?

 

  • Company profile. While net profit margin is a better measure than simply the net profit for comparing two companies in the same industry, one should still be careful in taking it at face value. Let’s take the above mentioned small business with a 17% net profit margin. It would naturally have smaller expenses, which would translate to a possibly higher net profit margin. However, this does not mean that they are automatically performing better than the more established company with a lower net profit margin of 5%, as that percentage could actually be in millions.
  • Location. When comparing companies’ net profit margin, it’s important to take into consideration the location, as the average percentage in a suburban area can be higher or lower than in a bigger, busier city.
  • Industry. Net profit margin per industry varies. For instance, in retail, the average may be at 6%, while in advertising, it can be around 10%.

 

It is crucial to go out and look at current trends based on these factors mentioned above, to get a better gauge of the net profit margin.

 

What Affects Net Profit Margin

 

Ultimately, high sales should mean high net profit should mean high net profit margin. Right? Sure, if all other factors remain constant. However, the whole financial statement of a company boils down to its net profit, which in turn translates to the net profit margin. It changes based on the other items in a financial statement, such as the expenses, cost of goods, taxes, and accounting practices. Let’s look at them in detail.

 

  • Sales. As mentioned above, higher sales would naturally increase net profit margin, assuming all other factors are under control.
  • Cost of goods. When suppliers increase or decrease their prices, the net profit margin will also be affected, even if the amount of sales is the same.
  • Company expenses. A sudden drop in the net profit margin can mean that there was a one-time expense such as payment for a lawsuit, taxes, or acquisition of new equipment.
  • Company strategies. On the other hand, a sudden surge in net profit margin can sometimes be attributed to short-term strategies such as suspension of marketing activities and/or research and development.  
  • Accounting. Because companies need to comply with accounting standards, their financial statement may include non-cash expenses that may significantly affect their net profit margin. Thus, even though cash flow is high, the net profit margin can be low.

 

In Conclusion … 

 

It is highly crucial for any company to ensure that their financial statements are updated, accurate and trustworthy. If so, then owners and investors can be confident in using their net profit margin for decisions that would forward their companies. If you need expert help in understanding and managing your accounts, beep me up! 

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Annette Ferguson

Annette Ferguson

Owner of Annette & Co. - Chartered Accountants & Certifed Profit First Professionals. Helping Online service-based entrepreneurs find clarity in their numbers, increase wealth and have more money in their pockets.