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Net Profit Margin

Net income divided by total revenue, expressed as a percentage

What is Net Profit Margin?

Net Profit Margin (also known as “Profit Margin” or “Net Profit Margin Ratio”) is a ratio used to calculate the percentage of profit a company produces from its total revenue. It measures the amount of net profit a company obtains per dollar of revenue gained. The profit margin is equal to net profit (also known as net income) divided by total revenue, expressed as a percentage.

Net Profit Margin Ratio

The typical profit margin ratio of each company can be different depending on which industry the company is in. As a financial analyst, it’s important in day-to-day financial analysis.

 

Example of Net Profit Margin Ratio Formula

 

Source: CFI financial analysis fundamentals course.

 

Net Profit Margin Formula

Net Profit margin = Net Profit  ⁄  Total revenue x 100

 

Net profit is calculated by deducting all company expenses from its total revenue. The result of the profit margin calculation is a percentage – for example, a 10% profit margin means for each $1 of revenue the company earns $0.10 in net profit. Revenue represents the total sales of the company in a period.

 

Calculation Example #1

Company XYZ and ABC both operate in the same industry. Which company has a higher ratio?

Net Profit Margin - Example 1

Step 1: Write out formula

Net Profit Margin = Net Profit/Revenue

 

Step 2: Calculate net profit margin for each company

Company XYZ:

Net Profit Margin = Net Profit/Revenue = $30/$100 = 30%

Company ABC:

Net Profit Margin = Net Profit/Revenue = $80/$225 = 35.56%

Company ABC has a higher net profit margin.

 

Calculation Example #2

Company A and company B have net profit margins of 12% and 15% respectively. Both companies earned $150 in revenue. How much net profit did each company make?

Step 1: Write out formula

Net Profit Margin = Net Profit/Revenue

Net Profit = Net Profit Margin * Revenue

Step 2: Calculate net profit for each company

Company A:

Net Profit = Net Profit Margin * Revenue = 12% * $150 = $18

Company B:

Net Profit = Net Profit Margin * Revenue = 15% * $150 = $22.50

 

Calculation Example #3

Company A and B earned $83.50 and $67.22 in net profit respectively. Both companies have a net profit margin of 18.22%. How much revenue did each company earn?

 

Step 1: Write out formula

Net Profit Margin = Net Profit/Revenue

Revenue = Net Profit/Net Profit Margin

 

Step 2: Calculate revenue for each company

Company A:

Revenue = $83.50/18.22% = $458.29

Company B:

Revenue = $67.22/18.22% = $368.94

 

Understanding the Ratio

The profit margin ratio is used to describe a company’s ability to produce profit and to consider several scenarios like an increase in expenses, which are deemed ineffective, and used extensively in financial modeling and company valuation.

Net profit margin is a strong indicator of a firm’s overall success and is usually stated as a percentage. However, keep in mind that a single number in a company report is rarely adequate to point out overall company performance; an increase in revenue might translate to a loss if followed by an increase in expense. On the other hand, a decrease in revenue, followed by tight control over expenses, might put the company in profit.

Other common margins are EBITDA and Gross Profit.

A high net profit margin means that a company is able to effectively control its costs and/or provide goods or services at a price significantly higher than its costs. Therefore, a high ratio can result from:

  • Efficient management
  • Low costs (expenses)
  • Strong pricing strategies

 

A low net profit margin means that a company uses an ineffective cost structure and/or poor pricing strategies. Therefore, a low ratio can result from:

  • Inefficient management
  • High costs (expenses)
  • Weak pricing strategies

 

Investors need to take numbers from the profit margin ratio as an overall image of company profitability performance and initiate deeper research on the cause of an increase or decrease in the profitability as needed.

 

Limitations of Net Profit Margin Ratio

When calculating the net profit margin ratio, analysts commonly compare the different companies’ ratios to determine which company performs the best.

While this is common practice, the net profit margin ratio could greatly differ between companies in different industries. For example, companies in an automotive industry may report a high profit margin ratio but lower revenue compared to a company in the food industry.  A company in the food industry may show a lower profit margin ratio, but higher revenue.

It is recommended to compare only companies in the same sector with similar business models.

Other limitations include the possibility of misinterpreting the net profit margin ratio and cash flow figures. A low net profit margin does not always indicate a poorly performing company. Also, a high net profit margin does not necessarily translate to high cash flows.

 

Limitations Example #1 – Comparing Companies

A jewellery company that sells a few expensive products may have a much higher net profit margin compared to a grocery store that sells many cheap products.

Limitations Example #1 - Comparing Companies

It’d be inappropriate to compare the margins for these two companies as their operations are completely different.

 

Limitations Example #2 – Companies with Debt

If a company has higher financial leverage than another, the firm with more debt financing may have a smaller net profit margin due to the higher interest expenses. This will negatively affect net profit, lowering the net profit margin for the company.

 

Limitations Example #3 – Depreciation Expense

Companies with high property plant & equipment assets will be affected by higher depreciation expenses, lowering the firm’s net profit margin. This may be misleading because the company could have significant cash flow but may seem inferior due to their low profit margin.

 

Limitations Example #4 – Manipulation of Profit

Management may reduce long-term expenses (such as research and development) to increase their profit in the short-term. This can mislead investors looking at net profit margins as a company can boost their margin temporarily.

 

Financial Analysis

Calculating the net profit margin of a business is a routine part of financial analysis. It is part of a type of analysis known as vertical analysis, which takes every line item on the income statement and divides it into revenue. To compare the margin for a company on a year-over-year (YoY) basis, a horizontal analysis is performed. To learn more, read CFI’s free guide to analyzing financial statements.

To learn more via online courses, check out our wide ranges of topics such as:

profit margin in financial analysis

 

Also be sure to explore our interactive Career Map to see which jobs perform this type of analysis.

If you want to become a financial analyst check out our certifications today!

 

 

Additional Resources

Thank you for reading our guide to the net margin formula. CFI is the official global provider of the Financial Modeling and Valuation Analyst (FMVA)™ certification, designed to transform anyone into a world-class financial analyst.

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