Net Profit Ratio

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Description: The net profit percentage is the ratio of after-tax profits to net sales. It reveals the remaining profit after all costs of production and administration have been deducted from sales, and income taxes recognized. As such, it is one of the best measures of the overall results of a firm, especially when combined with an evaluation of how well it is using its working capital. Net profit is not an indicator of cash flows, since net profit incorporates a number of non-cash expenses, such as accrued expenses and depreciation.

Formula: The formula for the net profit ratio is to divide net profit by net sales, and then multiply by 100. The formula is:

(Net profit / Net sales) x 100

Example: The Ottoman Tile Company has $1,000,000 of sales in its most recent month, as well as sales returns of $40,000, a cost of goods sold (CGS) of $550,000, and administrative expenses of $360,000. The income tax rate is 35%. The calculation of its net profit percentage is:

$1,000,000 Sales - $40,000 Sales returns = $960,000 Net sales

$960,000 Net sales - $550,000 CGS - $360,000 Administrative = $50,000 Income before tax

$50,000 Income before tax x (1 - 0.35) = $32,500 Profit after tax

($32,500 profit after tax / $960,000 Net sales) x 100 = 3.4% Net profit ratio

Cautions: The net profit ratio is really a short-term measurement, because it does not reveal a company's actions to maintain profitability over the long term, as may be indicated by the level of capital investment or research and development expenditures. Also, a company may delay a variety of discretionary expenses, such as maintenance, to make its net profit ratio look better than it normally is. Consequently, you show evaluate the net profit ratio alongside a variety of other metrics to gain a full picture of a company's ability to continue as a going concern.

Another issue with the net profit margin is that a company may intentionally keep it low in accordance with a low-pricing strategy that aims to grab market share in exchange for low profitability. In such cases, it may be a mistake to assume that a company is doing poorly, when in fact it may own the bulk of the market share precisely because of its low margins.