What’s it: Net profit margin is a profitability ratio to measure how much profit is left (in percent) after the company has covered all its costs, including interest expense and taxes. We calculate it by dividing net profit by revenue. We also call this ratio net income margin, net margin, or net earning margin.
A higher net profit margin than the previous period or the industry average is preferable. It shows a better performance where the company generates more profit as it books revenue at efficient cost.
What is net income?
Net income is a metric on the income statement to show how much revenue is left after paying all its expenses. It takes into account both operational and non-operational components.
But, remember, net income is not the same as the money the company actually makes. It still takes into account non-cash items, such as depreciation and amortization. And, to see the amount of money the company made during the accounting period, we must exclude those items. In this case, we can use the EBITDA metric.
Companies must maximize revenue and minimize costs to achieve a high net profit. It doesn’t just require management to figure out how to sell more products and get raw materials cheaper. But, it also requires them to think about the operation as a whole, including how to manufacture products and market them at lower costs, increase human resource productivity, and get loans at lower interest rates.
Net profit vs. gross profit
Gross profit represents the revenue remaining after the company covers the direct costs associated with producing the goods sold. We calculate it by subtracting revenue from the cost of goods sold (HPP). Gross profit only considers costs such as raw materials, packaging, and direct labor.
In contrast, net profit or net income considers all costs, including COGS. Therefore, we also include selling, general, and administrative expenses. In addition, financial expenses such as interest are also considered, as are translation gains (losses) and proceeds from asset sales.
In conclusion, gross profit describes profit in part, i.e., how profitable the company’s production is. Meanwhile, net income describes how profitable its overall operations are, including its marketing activities, capital structure, and human resource management.
Why is net profit margin important?
Net income margin is an important metric for measuring financial health, especially profitability. It tells us how profitable the company’s business is overall.
Investors use this ratio to evaluate its performance relative to its competitors. They review whether the company is making enough revenue from its business and efficiently generating it.
Since net income represents the remaining income after adjusting for operating expenses and non-operating gains (losses), it expresses the efficiency in generating profits. When efficient, companies generate high profits relative to booked revenues (higher margins). In other words, the company generates revenue at a low cost.
How to calculate net profit margin?
We calculate the net profit margin by dividing net income by revenue. That’s easy because the numbers are already presented in the income statement. Net income is at the bottom – that’s why it’s called the bottom line, while revenue is at the top – because it’s called the top line.
- Net profit margin = Net profit/Revenue
Take a simple example. A company reports revenue of $4 million and cost of goods sold of $1 million. The company also posted operating expenses of $2 million. Meanwhile, non-operating profit (loss) is equal to $200,000.
In this example, net profit equals $800,000 = $4 million – $1 million – $2 million – $200,000. Thus, the company’s net profit margin is 20.0% = $800,000 / $4 million.
How to interpret net profit margin?
Net income margin measures the percentage of profit left after paying all costs. A higher margin indicates higher profitability and is, therefore, more desirable.
On the other hand, a low net profit margin indicates poor performance. That may be because revenues are declining and not accompanied by cost reductions through efficiency measures. Thus, a further decrease in revenue will lower profits or even result in a net loss. Or, the company generates higher revenue but at a higher cost, where the percentage increase in costs is higher than the increase in revenue.
Comparing net profit margin historically and with the industry average
When comparing historical net profit margin, it gives an idea of whether the company’s performance is improving or not. An increasing percentage generally indicates improvement. Otherwise, it indicates the worse.
Then, comparing with the industry average allows us to know the company’s performance relative to its competitors in the market. Net profit margin varies across industries. Companies in the same industry face the same external environmental opportunities and threats. Thus, comparing the net profit margins between them makes more sense than comparing companies in different industries.
For example, some industries like food have lower margins than companies in the fashion industry. The food industry generally faces high price fluctuations and competitive pressures, which is not the case in the fashion industry.
Then, being under the same pressure and having similar opportunities, a higher margin than the average competitor in the industry indicates better performance. It could result from a more competitive market position, so the company has better pricing power. Or, it is due to more efficient operation resulting in lower costs.
Check operational and non-operational components
A high net profit margin is preferred if it is mostly contributed from operational components instead of non-operating. It shows the company is succeeding in generating more revenue and managing expenses in its core business.
The opposite condition is unwelcome. Non-operating items usually do not recur. As a result, the company may post a fairly high non-operating profit this year but not continue next.
Now, take asset sales as an example. Such one-time items can significantly impact the margin because they have significant value. Thus, the company may still generate net profit even though it posted an operating loss. However, in subsequent periods, when it was not accompanied by improvements in revenue and cost efficiency, the company posted a significant net loss as it no longer reported the proceeds from the sale of assets.
