What Is the Net Profit Margin?
Find out How Your Net Profit Margin Ratio Affects Your Business
There are many measurements that can be used to reveal the financial performance of your business. One of the most popular measurements is the net profit margin. The net profit margin is a profitability measurement. It represents the percentage of profit from business operations after you've deducted all your expenses.
All financial measurements—also known as metrics—use information from your company's financial statements, using formulas for calculation. The three main financial statements are the balance sheet, income statement, and statement of cash flows. The income statement is used to gather the information needed for the net profit margin.
Net Profit Margin Formula
The formula for the net profit margin is (result is in percent form):
(Net Profits ÷ Net Sales) x 100
Elements of the Formula
You'll have to calculate net profit and net sales, as there are generally not line items labeled as such on the income statement. Net profit is calculated by subtracting all of your expenses from your revenues. These include wages, salaries, utilities, or other expenses.
Net Profit = Total Revenues - All Expenses
Net sales is the result of subtracting your allowances, returns, and discounts from your total revenue. Allowances stem from problems with a product or service which required you to reduce the price to satisfy the customer. A return is the return of an item or a refund for a service.
Net Sales = Total Revenues - Allowances - Returns - Discounts
Interpreting Your Net Profit Margin
The net profit margin can indicate how well the company converts its sales into profits. This means that the percentage calculated is the percent of your revenues that are profitable. It also indicates the amount of revenue you are spending to produce your products or services.
Both net sales and net income are related to each other in that expenses can increase prices, which can decrease sales depending on your product and audience. Net sales could increase as a by-product of an increase in expenses if expenses increased the quality of your product. Conversely, net sales could decrease as a result of increased expenses if sales prices were raised to compensate.
Companies that generate greater profit per dollar of sales are more efficient. Companies with high net profit margin ratios are also better able to survive a product line that doesn't meet expectations or a period of economic contraction.
Economies go through cycles. After the economy peaks (maximum growth), it enters a phase called contraction (the economy has ceased to grow and is shrinking), in which it is headed toward a trough (the bottom of the cycle, maximum shrinkage).
Debt financing, or using loans or other means of credit to finance your operations, can reduce your net profit margin. If you decide to finance with debt financing, you would see an increase in interest expenses, which could skew your net profit margin toward an undesirable level.
The net profit margin can be used to compare performance over different periods. However, this only reveals reliable results if nothing else has changed in your expenses.
As you continue to analyze your business' financial results and performance, you may make adjustments in expenditures over time. Be aware that as you do this, it decreases the comparability of this measurement over multiple periods.