Net Profit Ratio or Margin

Net profit margin is one of the profitability ratios and an important tool for financial analysis. It is the final output, any business is looking out for. Net profit ratio is a ratio of net profits after taxes to the net sales of a firm. All the efforts and decision making in the business is to achieve a higher net profit margin with an increase in net profits.

Net profit margin shows the margin left for the equity and preference shareholders i.e. the owners. Unlike the gross profit which measures the operating efficiency of the business, net profit margin measures the overall efficiency of the business. An adequate margin of net profits will be generated only when most of all the activities are being done efficiently. The activities may be production, administration, selling, financing, pricing, tax management or inventory management.
Even if any of these perform badly, the effect on net profits and their margins can be seen.

For example, inventory management had some problem in a particular year and profit margins fell down. Net Profit Ratio or MarginThe management needs to focus on that part to regain the same ratios. One way of helping to ensure profit margins is to use a third-party logistics company to help manage inventory. Once the said problem is resolved, the company can again see the rise in their margins.

How to Calculate Net Profit Margin Ratio?

Formula for net profit margin is as follows:

Net Profit Margin Ratio = Net Profit

Net Sales

The calculation of net profit margin does involve too many calculations but deciding which profit to be taken for calculation is a concern. The different levels of profits can be

  • Profit before Interest and Taxes (PBIT): There are many authors of financial management who are in favor of using PBIT for the calculation of net profit margins because it nullifies the effect of modes of finance. This is particularly useful when the purpose of calculating net profit margin is to assess the operating efficiency of the business. With this profit, the ratio can be comparable to the industry and competitors.
  • Profit after Taxes (PAT):
    This profit is the taken in the conventional way of calculating the ratio. The margin when calculated with PAT shows the effect of all the activities of the business considering that the financing of assets is not a separate activity but an important activity of the business.

Interpretation of Net Profit Margin / Net Margin / Net Profit Ratio:

The percentage shown by net profit margin does not have any specific benchmark. It is because the net profit margin of a small business and big steel plant cannot be same and therefore a standard benchmark cannot be set. The interpretation is more meaningful when the data of more than one period are available or the industry or competitor’s net profit margins are available.

Comparison with Past Periods: It is normally advisable to have improved net margins compared to the previous periods. If the margins are not improved, it calls for careful analysis to find out the reasons behind the decline. Since the net margins are dependent on many factors starting from the cost of production till the taxes paid in a profit and loss account.

Comparison with Competitors or Industry: If the margins are not as good as the competitors have, it is sure that there is some deficiency in the business operations. With same industry and same economic conditions, two businesses should normally have same profit margins. A major negative deviation in the profit margins is a serious matter to be handled with extensive care. Since profits are the lifeblood of any business. Any compromise in profits may raise a question mark on the sustainability of the business.

Last updated on : August 31st, 2017
What’s your view on this? Share it in comments below.

Leave a Reply

Difference between Breakeven Point vs. Margin of …
  • Common Size Financial Statement
    Common Size Financial Statements
  • Acid Test Ratio
    Quick Ratio
  • Gross Profit Margin
    Gross Profit Margin
  • What is Benchmarking? Types and Limitations of using it
    What is Benchmarking? Types and Limitations of …
  • Subscribe to Blog via Email

    Enter your email address to subscribe to this blog and receive notifications of new posts by email.

    Join 122 other subscribers

    Recent Posts

    Find us on Facebook

    Related pages

    gross profit margin ratio analysisfixed charge coverage ratio formulaoverdraft interest calculationdebtors turnover ratio formula in daysreceivables collection period ratiohow to calculate payback period in project managementshare price formula investopedialeverages meaningwhat is debenture bondgaap capitalization rulesadvantages and disadvantages of weighted average cost methodcommon size financialsirr calcualtiondividends per share definitionstages of capital budgetingcapital budgeting involvesnegative covenant examplesasset utilization formulaearning per share calculationformula for days sales in inventoryyield to maturity calculation formuladifference between debentures and bondsliveragesdisadvantages of cash flow forecastdefine capital expenditure budgetecb rbi guidelineswacc calculation examplesdisadvantages of financial ratiosdefine debenturesorigin of the word debitsemi fixed cost definitionhypothecation of securitieslease accounting entriesunsecured debenturedeferred coupon bondhow to calculate ebit exampleloan tenor definitiondisadvantages of accounting ratioshow to calculate closing stock without gross profitcalculate shareholders equitystakeholder and shareholderirr solved problemsoverdraft in accountingstock to sales ratio formuladisadvantages of selling sharestransferable standby letter of credittypes of financial ratios and their formulaswhat are the macro environmental factorscapital lease ifrstrade creditors accounts payablecapm limitationtypes of bill of lading in shippingconglomerate diversification exampleslesse vs lessorcredits and debits made easydifference between cost accounting and financial accounting pptlessor accounting exampleratio analysis involves analyzing financial statementsaccelerated depreciation methodscapitalized interest expensedifference between stockholder and shareholderplain vanilla derivativesadvantages and disadvantages of financial leverageleasor vs leaseeneed of corporate restructuringdepreciation in cost of goods soldmm theory of dividend policyaverage collection period calculatormeaning of debentureirr explanationcapital lease accounting treatmentbills receivable and bills payable meaningactivity based budgeting examplepreferred shares cumulativelength of operating cycle formulashogun bond