What Is the Net Profit Margin Ratio?
Find out How Your Net Profit Margin Ratio Affects Your Business
If you are running a business and plan to expand, it's essential that you understand your company's net profit ratio. The net profit margin ratio is a profitability ratio and it represents the percentage of profit from business operations after you've deducted business operating expenses, interest expense, taxes and preferred stock dividends from revenues.
Common stock dividends are the only major debt item left out of the equation. This is because, technically, common stock dividends aren't expenses, they're profits distributed to stockholders. Further, dividends aren't obligatory payments. A company's board declares the dividend and that same board can also reduce or suspend dividends at any time.
The Net Profit Margin Ratio Calculation
Calculating the net profit margin ratio isn't at all complicated but requires getting some information from the company's income statement:
- Net Income: Net income = gross income - expenses. Gross income in many instances is the same thing as sales revenue, although they can differ if certain exclusions are allowed; for instance, stock options granted to company executives. For this example, assume this is the basic case where the gross income and sales revenue are the same things. To arrive at net income for a specific time period, often a quarter or a year, you subtract from gross income all business expenses for the same time period. These include all operating costs, interest, tax payments and preferred stock dividends if any. The remainder is net income.
- Net Sales: Net sales are simply sales revenue with any returns and allowances subtracted out.
With these two figures in hand, you can calculate the net profit margin ratio:
Net Profit Margin Ratio = Net Income/Net Sales
Interpreting the Net Profit Margin Ratio
When you look at the net profit margin ratio, you see that the numerator (net income) is affected by the company's actions to reduce expenses and the denominator (net sales) is affected by the company's actions to increase sales revenue. Both actions will increase the net profit margin ratio.
The net profit margin indicates how well the company converts its sales into profits, and how its expenses correlate with those of other similar companies. It's both a measure of efficiency and of overall business health.
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.
The net profit margin ratio is also a good time-series analysis measure, whereby business owners can look at company data across different time periods to see how the business is trending. A comparative analysis can highlight profit areas that have deteriorated or reveal increased cost trends that are reducing net profit. Financial ratios like the net profit margin ratio become most meaningful when they are viewed from several data points over time.
The usefulness of the ratio, like all business data, has some limitations. Since industries are so different, the net profit margin is not very good at comparing companies in different industries. It is better at comparing similar businesses, not only ones in the same industry, but ones of similar size, or with similar product lines or doing business in the same broad geographic area.