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6 Min. Read

Net Profit Margin: Definition, Example & Calculation

Net Profit Margin: Definition, Example & Calculation

Not many would argue that profit is the most important part of a business. Driving to increase profits tends to increase every other aspect of a business. But how is profit expressed? Well, one of the most common ways to express profit is through the net profit margin. Understanding how to calculate and determine your net profit margin is key in success. It can influence all sorts of business operators. Learn more about net profit margin here!

Here’s What We’ll Cover:

Defining Net Profit Margin

The Net Profit Margin Formula

Why is Net Profit Margin Important?

Key Takeaways

Defining Net Profit Margin

Net profit margin, sometimes just called net margin, is a financial ratio. It measures how much net income is generated as a percentage of revenue. It is normally expressed as a profit percentage, but is seen as a decimal sometimes. It demonstrates how much of each dollar in revenue collected is considered profit. Most professionals agree that net profit margins are the most important financial metrics. A healthy profit margin indicates the well-being of a company’s financial health.

How are Net Profit Margins Used in Business?

Net profit margins indicate a company’s financial health. By examining them, a business owner can determine if current business models are working. When these margins increase and decrease, professionals can forecast profits based on revenue. Additionally, this metric is expressed as a percentage. That means that all businesses can be compared, regardless of size.

Publicly traded companies report net profit margins frequently. They’ll do it every quarter at a minimum, during earnings releases. Other companies will report this information more often, and will report it annually as well. Companies that can prove that they can increase profit margins are rewarded by more financial support.

How Do Investors Use Net Margins?

Investors use net margins as well. They review the margins to determine if a company’s management is generating enough profit from sales. Additionally, they use it to make the assumption about whether costs are being controlled or not. These costs include operating expenses and overhead costs. Investors want to see companies that have growing revenue without growing costs. This is an indicator of increased profits.

All Operations are Included in Net Margins

When calculating net profit margin, all aspects of operations are included. This includes all operational expenses, as well as non-operational costs. It also includes all forms of income. Check out the total list below.

  • Total revenue
  • All outgoing cash flow
  • All income streams
  • Cost of goods sold (COGS)
  • Other operating expenses
  • Debt payments, including interest
  • Investment income
  • Income from secondary operations
  • One-time payments (unusual events like legal settlements and taxes)

The Net Profit Margin Formula

To calculate the net profit margin, a simple formula can be used. Using information found in more than one financial statement, any company’s margins can be determined. Most of the information for the below formula can be found on the income statement.

Net Profit Margin = ((Revenue - COGS - Expenses - Interest - Taxes ) / Revenue ) x 100

To calculate this information step by step, see the below guide.

  1. Subtract the cost of goods sold (COGS), expenses, interest, and taxes from revenue.
  2. Take the result and divide it by the figure for revenue.
  3. Multiply the result by 100 to create a percentage.

An easier way of accomplishing this is to divide a company’s net income by their revenue. Then multiply by 100. The result will be the net profit margin ratio. This percentage can be used to determine a company’s profitability.

An Example Using Improvised Numbers

A company has the following figures listed on their income statement. This information can be plugged into the formula above to determine the net margin.

  • Revenue: $10,000
  • Operating Costs: $1,500
  • COGS: $1,250
  • Tax Liability: $3,000

Plug these figures into the formula and it should look something like this:

Net Profit Margin = ((10,000 - 1,500 - 1,250 - 3,000) / 10,000) x 100

Net Profit Margin = (4,250 / 10,000) x 100

Net Profit Margin = 0.425 x 100

Net Profit Margin = 42.5%

This company’s net profit margin is 42.5%. This means that for every dollar of revenue, 42.5 cents is profit.

Why is Net Profit Margin Important?

This figure indicates a company’s overall profitability. It tells a business if their financial endeavors need to be reviewed or refined to increase profits. Businesses want to have a net profit margin as high as possible. However, this figure will never reach 100%. To do that, they’d have to have absolutely no operating costs. This is unrealistic.

How Does a Company Increase Net Margins?

There are two main ways of increasing net margins. This is done either by boosting sales or reducing expenses.

When approaching this problem, most companies will opt to reduce expenses. This is because reducing expenses doesn’t tend to have an impact on current sales. Cost reduction may take more work to do than boosting sales, but it is the most cost-effective solution.

Boosting sales is desirable, yes. However, to boost sales under normal circumstances, costs have to be increased. Sales boosts are a side effect of marketing and advertising. Both of these are expensive actions to take. The predicament is that spending money may not boost sales in the way a business expects. If sales fall short after increasing costs, the profit margin of a business suffers further.

Industries Have Different Standards for Margins

Expected net profit margins are different from industry to industry. This is because the operational costs of different industries vary. It cannot be expected for high cost businesses to exceed certain margins. As such, the rate of success can only be compared between businesses in the same industries. It can’t be used effectively for businesses that are too different from one another.

Key Takeaways

If you were to conduct interviews with industry experts, you’d find that most of them find net profit margin to be highly important. This measure of business indicates if a company is performing well in its industry. Profits are the most important part of a business. By understanding how net profit margin works, you can lead your business to success. If you’re looking for more articles like this, be sure to check out our resource hub!