Net Profit Margin is also called Profit Margin, or Net Profit Margin Ratio. This financial ratio is mainly used for calculating the percentage of profit that a company generates out of its total revenue. It helps to measure the amount of net profit a company obtains per rupee of revenue generated. Net profit margin is expressed as a percentage and is equal to net profit or net income divided by total revenue.
How to calculate net profit margin?
Net profit margin calculation begins with estimating the net income of the organisation. Since companies publish their financial reports periodically, one can see the net income stated as a separate item in their Income Statements. To manually arrive at a company’s net income, one must deduct the following items from its total revenue:
- Cost of goods sold
- Cash outflow pertinent to a specific accounting period
- Administrative overheads like salary
- Research and development expenses
- Depreciation
- Interest on debt
- Tax
Mentioned below is the formula for arriving at net profit margin:
Net profit margin = (Net income / Total revenue) x 100
It is important to note that net profit margin can be either negative or positive, depending on the net income. A negative net profit margin indicates non-profitability for the specific period.
How to use net profit margin to evaluate a company
Net profit margin is used by investors to compare a company’s performance across different reporting periods and also against its competitors. If a company has undertaken a strategic initiative to boost its profitability, investors can estimate net profit margin for evaluating the effectiveness of the initiative and whether it can deliver results. If the company’s net profit margin is seen to be declining, investors can consider it as an indication of deteriorating financial health.
A company that has a higher net profit margin as compared to its peers is seen to be efficiently converting its revenues into profit. If, however, a company’s net profit margin is lower than its peers, it can be a sign of financial weakness or as being less efficient than its competitors.
What is the importance of Net Profit Margin?
Net profit margin considers all the expenses and revenues of a company. This makes it a crucial profitability metric. Here are some of the key reasons why this metric is crucial from an investor perspective and also for the company’s financial decisions:
- Net profit margin helps in assessing costs and pricing. A higher net profit margin indicates an effective pricing strategy of a company and efficiency in keeping its expenses low. A lower profit margin indicates to the company management that there is a need to re-evaluate the cost and pricing strategy for increasing profitability.
- Banks and lenders may use it for evaluating risk of granting the company a loan or credit. Banks are usually willing to extend loans to a company that has a high profit margin since it signifies that the company has a strong cash flow and therefore higher chance of paying back the loan on time.
- It allows investors to draw a comparison between companies. Since net profit margin is a percentage of a company’s total revenue, it can be used for comparing companies of varying sizes within the same industry.
What are the limitations to net profit margin?
Although net profit margin is a very useful metric, it has certain limitations. Listed here are some of them:
- Net profit margin may not be ideal for comparing companies in different sectors. This is because in some industries, low net profit margins may be considered good, while in other sectors, higher net profit margins may be more acceptable.
- Net profit margin metric can vary significantly across different reporting periods because of the potentially enlarged effects of one time events. For example, asset sales may temporarily boost income and inflate the net profit margin. Similarly, one time expenses can weigh down a company’s profitability in a reporting period.
Thus, it’s important to understand the factors influencing net profit margin during any given period while determining whether this metric is appropriate for evaluating a company.
Conclusion
Net profit margin is one of many financial metrics that can be used by investors to analyze a company’s profitability. Therefore, investors must ensure to use a combination of metrics instead of solely relying on one method of measuring the investment worthiness of a company.
FAQs
Gross profit margin is calculated as gross profit divided by total revenue (before considering the expenses), multiplied by 100. It tells us the percentage of income retained as profit after considering the cost of goods. Net profit margin is the percentage of net income generated from a company’s revenue.
Net profit margin is also called a company’s bottom line. Therefore, it is arrived after considering all expenses, including tax and one-off spending.
Some of the ratios that investors must consider while making an investment decision on a company include profit margin, operating cash flow margin, debt-to-equity ratio, earnings per share, etc.
While investing in a company, you must closely examine the net profit margin of the company, assess its year on year income growth, check its competitive advantage, consider its business model among other factors.
Beginners could try investing in passive investment alternatives, such as ETFs or index funds. This helps them gain exposure to the equity markets despite carrying limited knowledge of stocks and contains overall risk related to stock markets.
