Introduction to net profit margin

Net profit margin, also known as ‘profit margin’ or ’net profit margin ratio’, is the percentage of revenue remaining after you have factored in cost of goods sold, operating costs or expenses, taxes, interest, and preferred stock dividends, excluding common stock dividends. In other words, it is a ratio which shows the percentage of profit a company produces from its total revenue, or what percentage of your sales is actual profit.

However, before we proceed further it is important to first get a better understanding of what revenue and operating expenses are. Going forward it will help us better comprehend and calculate net profit margin.

What is ‘revenue’?

Revenue, also called sales (or turnover), is the total sales a company has made selling its products and services. If you subtract returns and discounts from total sales, you get net revenue.

How revenue works?

For example, a stationery shop sells £40,000 worth of goods for the year. This sale is recorded on the very top of its income statement as revenue.

Why revenue matters

Revenue displays the total amount of sales a business is making in a financial year. A steadily rising revenue points to the fact that the company is making more sales and the prospect of its growth is bright. On the other hand, diminishing revenues can signal that the organisation is faltering. In other words, the more revenue a company generates the more money it has in hand which can be put to other purposes like expansion, capital investment, etc.

What is ‘operating expense’?

Operating expenses refer to the expenses borne by the company in its normal day-to-day business operation. These expenses are recorded in the income statement for bookkeeping purposes.

How operating expenses work?

Operating expenses are the daily costs associated with running a business’s core operation, like the cost of goods sold, cost associated with utilities, salaries, rent, etc.

Why operating expenses matter?

Operating expenses play a very important role in calculation of operating income. And when we talk about operating income it is a measure of profitability that tells investors how much of revenue generated by the organisation is going to show as profit. As such, operating income is a key determinant of the financial health of an organisation. It is pretty simple to comprehend in that the lower the operating expenses, the more profitable an organisation is going to be.

After gaining some knowledge about operating expenses and revenue, it is time to return to net profit margin.

Net profit margin formula

The profit margin is equal to net profit (also known as net income) divided by total revenue, expressed as a percentage.

Net profit is calculated as: total revenue – total expenses

Net profit margin as such will be: net profit/total revenue

Multiply it by 100 to get it as a percentage (%).

For example, a 20% profit margin means for each £1 of revenue the company earns £0.20 in net profit.

Division of net profit by total sales or revenue is a good measure of determining the total revenue that made it all the way to the bottom line.

We can understand it better with the help of an example. Let us say that your business makes £20,000 in sales, the total cost of making your product comes up to be £10,000, and you spent another £2,000 on operating costs (such as overheads and taxes).

Total sales or revenue - (cost of goods sold + operating costs) = net income

£20,000 - (£10,000 + £2,000) = £8,000

Net income ÷ sales = net profit margin

£8,000 ÷ £20,000 = 0.4

0.4 × 100 = 40%

As the example demonstrates, the net profit margin of your business is 40%. In other words, 40% of your total sales revenue is profit.

Why net profit margin matters?

The importance of net profit margin can be determined from the fact that it is one of the most closely followed data in the financial world. Investors display a keen interest in this ratio as it tells them about the profit generating capacity of a business, which leaves the company with enough capital to indulge in expansion activities.

Net profit margin is not the same as cash flow

It is imperative to understand that net profit is not a measure of the amount of cash earned by the company in any given time period. This is because, as mentioned above,net profit is included in the income statement of a company which includes other non-cash expenses such as depreciation and amortisation. A cash flow statement of a company refers to the cash generated and used by that particular organisation during a given time period. The cash source of a businessas shown in a cash flow statement is broken down into three parts: cash flow from investing, operating and financial activities. Net income, in contrast, takes into account certain other expenses such as depreciation - which does not involve any cash flow.

Please note that the net profit of a company is closely scrutinised by stakeholders. A declining net profit margin is a pointer to myriad problems that may be plaguing a company, like expenses mismanagement, declining profit and sales, among other things. Net profit is not an absolute number and different organisations operating within the same industry are scrutinised for their net profit margin to determine which ones are doing a better job of converting their sales into profit.

Understanding the net profit margin ratio

As mentioned above, net profit margin is an organisation’s ability to generate profit from its sales. Net profit margin is an important determinant of how an organisation is performing. However, it is worth noting that its performance cannot be single-handedly determined by its net profit margin. There could be several factors contributing to a business’s performance, such as an increase in sales that may not result into increased profit if the company is inadequately managing its expenses. In contrast, a decrease in sales may lead to profit improvement if the company keeps its expenses in check.

An above-average net profit margin means that the firm is doing a good job of managing its expenses and the selling price of its goods is higher than its cost. As such, a high ratio can result from:

  • Efficient management.
  • Tight control over its costs.
  • Good pricing strategies.

On the other hand, a low profit margin means that the company is doing a poor job of checking its costs or it has an inefficient pricing mechanism in place. As such, a low ratio can result from:

  • Inefficient management.
  • Mismanaged expenses.
  • Poor pricing strategies.

Investors need to delve a bit deeper and not rely on superficial numbers alone to get to the root cause of an increase or decrease in a business’s overall net profit margin.

Examples of net profit margin with calculation

Company ‘Inma’ and company ‘Sigma’ have net profit margins of 12% and 15% respectively. Both companies earned £150 in revenue. How will you calculate the net profit of each company?

Start with the formula to calculate net profit margin

Net profit margin = Net profit/revenue

Net profit = Net profit margin * revenue

Calculate net profit for each company

Company Inma:

Net profit = net profit margin * revenue = 12% * £150 = £18

Company Sigma:

Net profit = Net profit margin * revenue = 15% * £150 = £22.50

Company ‘Zulu’ and company ‘Soho’ earned £83.50 and £67.22 in net profit respectively. Both companies have a net profit margin of 18.22%. What is the total revenue earned by each company?

What is the impact of a negative net profit margin?

Businesses with large-scale operations and good reputations also suffer losses occasionally. Economic downturns, unprofitable ventures, bad investment decisions, expansion, etc all have the potential to hurt a company’s net profit margin. An overall negative profit margin implies that the business is earning less than its expenditure. However, a negative profit margin for a short period of time should not necessarily induce panic as businesses with a sound pricing policy and effective cost-cutting mechanism can successfully override this temporary turbulence.

Financing

If your business is experiencing negative net profit margin, you may experience difficulties in managing your cash flow because your revenue does not have enough cash to cover your expenses. Seeking business financing can provide temporary relief as you go about correcting things. However, a business with negative profit margin may find it hard to secure financing from established channels and may have to seek money through unsecured channels, such as credit lines and credit cards. Please remember that financing to cover negative profitability should be a stop-gap arrangement to turn your fortunes around. Allow it to linger for some time and the situation may spiral out of control.

Taxes

Having a negative net profit margin can diminish your tax liability as taxes are imposed on your profitability. Negative net profit means no profit and as such no taxes imposed. This, however, is small consolation as the money you are losing is significant in relation to what you may be saving in taxes.

Operations

A business that has a negative net profit margin should closely assess its operating costs to get to the root of the problem and rectify the problem as soon as possible, before the situation deteriorates. Review your books carefully to determine where you are bleeding from; whether you are spending more than you should on things like rent, materials or payroll. Try to rectify unsustainable expenditure patterns through efficient management of resources, revenue augmentation by expanding into new markets and doing away with processes and systems that are hurting the net profit margin.

Long-term loss

As mentioned above, short-term negative profit margin is not, and should not be, a cause of acute distress as it can be reversed with efficient expense management and sound pricing strategies. In sharp contrast, if your business sustains long-term loss, it is a sign of a deeper malady and a problem that has next to no chance of salvation. Under such circumstances, the prudent thing to do is to close the shutters and look for a new opportunity.

Limitations of the net profit margin ratio

Financial analysts and experts determine the overall performance of an organisation by looking at its net profit and comparing it with the net profit of peers. While this is common practice, there is an inherent limitation to this method. The primary reason for it is so businesses operating in different industries may have different expected levels of net profit margin. For example, a company in the smart phone sector may report a high profit margin ratio and a low revenue in contrast to an organisation operating in the food sector whose revenue may be more, but overall profitability will be less. It is the reason it is generally recommended to compare net profit of companies operating in the same industry and with similar business models. Another major limitation of calculating net profit margin is that it is often confused with cash flow. As mentioned above, this is a mistake as net profit takes into account certain other expenses such as depreciation which does not involve any cash flow.

Some of the limitations of net profit margin are:

Limitation 1 - Comparing companies operating in different markets

A company dealing in luxury goods may have a higher profit margin than a grocery store whose sales may be higher but profit lower, on account of selling low-priced goods. As such, it would be thoroughly inappropriate to judge the net profit of the luxury goods maker against that of a grocery store as their industry is totally different.

Limitation 2 - Companies with debt

An organisation with higher financial leverage (debt) may have a lower net profit margin as part of its income will go towards debt financing (interest payments). This will negatively affect the net profit margin of the company.

Limitation 3 - Depreciation Expense

Firms possessing high property, plant & equipment assets are likely to suffer more from higher depreciation expenses. This will depress the overall net profit margin; the company’s overall image as such could take a hit owing to a low profit margin despite strong cash flow.

Manipulation of profit

Management, in order to boost their net profit margin, may try to ‘cut corners’. For example, they may reduce the budget of R&D activities to show higher profit margin. This could be misleading for investors, who may be lured in by the healthy-looking net profit margin of the company, unaware of the fact that it is coming at a price.

Summary

Selling goods and services and generating enough revenue to cover the cost of running the business is critical for any organisation’s survival. If the company is unable to generate enough sales to cover its costs, it drags on its financial resources, leading to early closure of the business. Net profit margin or net profit ratio measures the overall profitability of the organisation, which helps investors and management assess the company’s performance.

Net profit margin is the percentage by which a company's total revenue exceeds, or is less than, its overall expenses. A positive net profit margin demonstrates that the company is running in profit, whereas a negative ratio indicates that the company is making less money than it is spending.

Calculating net profit margin

Net profit margin is calculated by subtracting total costs from total sales and then dividing it by total sales. For example, if a business has £2m in total revenue and its total costs equal £800,000, then its net profit margin is £1.2m.

Significance of net profit margin

Net profit margin essentially measures the amount of money accrued or profited after all expenses have been paid off. For example, if the net profit margin of a company is 20%, it means the company is making 20 pence of profit for each £1 of sales. To put it in simple terms, a higher net profit margin means a company is doing a good job of controlling its costs and its pricing strategies.

Summary

A company with a less-than-satisfactory net profit can take positive steps like reducing costs and increasing sales to better its profit margin. Cost-cutting measures such as implementing sound manufacturing policies that lower the overall production cost, retrenchment and jettisoning of loss-making projects can help boost net profit margin. Better pricing strategies, such as selling products or goods at higher costs, can also bolster net profit margin.