How To Calculate Net Profit Margin: Assessing the Financial Health of Your Small Business
Small businesses need to know how to calculate net profit margin to better understand their financial health. Net profit margin measures how much of a business’s sales is actual profit, after accounting for the cost of goods sold, operating costs and taxes. It tells you the ratio of net income to revenue and gives insights into the overall profitability of a company. Net profit margin differs from gross profit margin, which only measures revenues after the cost of goods sold, without factoring in any other costs. Net profit margin is calculated from a business’s income statement, which looks at the revenues, expenses and overall profit or loss generated by a business over a specific period of time. Generally speaking, companies with a higher profit margin are in a better financial position than businesses with lower profit margins. Small business owners should understand how to calculate net profit margin to evaluate whether their business practices are having a positive or negative impact on the company’s bottom line.
These topics offer easy solutions for how to calculate net profit margin:
How to Calculate Net Profit Margin
To calculate net profit margin, look at your business’s income sheet and note your revenue or total sales. Then, find your net income by subtracting these figures from your revenue:
- Cost of good sold
- Fixed costs
- Dividend payments (if your company pays stock dividends)
Finally, divide net income by revenue and multiply it by 100 to express it as a percentage. The final figure is your net profit margin.
Here’s the equation to follow when calculating net profit margin:
Net Profit Margin = (Total Revenue – Total Costs) / Revenue x 100
Net Profit Margin Calculation Example
This sample net profit margin calculation can help you better understand how to run the formula for your own business. Many of these calculations will already be prepared on your business’s income statement, but going through all the steps helps you better understand what profit margin is and how it’s calculated.
Company XYZ sold 50,000 units of its product in 2018 at a cost of $10 per unit. The cost of goods sold for the product was $6 per unit. The company’s operating expenses for the year totalled $25,000 and they paid $30,000 in taxes.
Step 1: First, find the company’s total earnings, which is the number of units sold multiplied by the cost per unit.
- Revenue = 50,000 x 10
- Revenue = 500,000
Step 2: Next, net income is calculated by subtracting from the total revenue the cost of goods sold, the operating expenses (fixed costs) and taxes. The cost of goods sold in this case is $6 x 50,000 units, or $300,000.
- Net income = 500,000 – (300,000 COGS + 25,000 operating expenses + 30,000 taxes)
- Net income = 500,000 – 355,000
- Net income = 145,000
Step 3: Finally, to calculate net profit margin, divide net income by revenue and multiply by 100.
- 145,000 / 500,000 = .29 X 100
- Net profit margin = 29 percent
What’s the Importance of Net Profit Margin?
Net profit margin is an important indicator of the financial health of your small business, because it tells you the real profit you’re generating from your sales after all your expenses are accounted for. Simply put, the net profit margin tells you how profitable your business is. Management can track a company’s net profit margin over time to see if current business practices are working and improving the bottom line. It can also help you forecast profits, to plan for the future of your business.
If you ever seek out a loan for your small business, lenders will look at your net profit margin before determining whether to lend you money. A company with a healthy net profit margin is more attractive to lenders, because a strong profit means you probably have a healthy cash flow and are therefore less likely to default on your debt.
Best Net Profit Margin Calculator
There are a number of easy-to-use net profit margin calculators available online if you don’t want to do the calculations yourself. One of the best net profit margin calculators available to use for free online is from Finance Formulas. You simply plug your figures from your income statement into the calculator and it will determine your business’s net profit margin for you.
What Is Considered a Healthy Operating Profit Margin?
A healthy operating margin depends on your industry and how much your business plans to grow in the future. Industries with low overhead expenses generally have a higher profit margin than industries with a higher overhead cost. So, for example, you’d expect a business consultant’s profit margin to typically be higher than that of a manufacturing business.
One way to determine whether your company’s profit margin is healthy is to compare it to a benchmark index, such as the S&P 500. In 2017, the average operating profit margin for the S&P 500 was around 11 percent. So, if your business’s operating margin is more than 11 percent, you’re outperforming the overall market, a sign of a healthy operating profit margin.
What Is a Good Net Profit Margin for a Service Business?
Net profit margin is often high for service businesses, because they tend to have lower operating costs than in other industries. The simpler your business structure, the higher your profit margins tend to be, because your expenses are lower. If your service business is a sole proprietorship with no employees, you don’t have the expense of worker salaries. And if you operate your service-based business from a home office, costs such as rent, utilities and insurance are lower than for more traditional businesses.
A study by Sageworks found that many service businesses have high net profit margins. For example, the average net profit margin for accounting businesses was 20 percent, law services had a net profit margin of 15 percent and design services businesses had a net profit margin of 11 percent.