The net profit percentage is the ratio of after-tax profits to net sales. It reveals the remaining profit after all costs of production, administration, and financing 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. The measure is commonly reported on a trend line, to judge performance over time. It is also used to compare the results of a business with its competitors.
Net profit is not an indicator of cash flows, since net profit incorporates a number of non-cash expenses, such as accrued expenses, amortization, and depreciation.
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
The measure could be modified for use by a nonprofit entity, if the change in net assets were to be used in the formula instead of net profit.
Example of the Net Profit Ratio
For 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
Issues with the Net Profit Ratio
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 expenditures for advertising, training, or research and development. 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 should 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. Conversely, the reverse strategy may result in a very high net profit ratio, but at the cost of only capturing a small market niche.
Another strategy that can artificially drive down the ratio is when a company's owners want to minimize taxes, and so accelerate the recognition of taxable income into the current reporting period. This approach is most commonly found in a privately held business, where there is no need to impress outside investors with the results of operations.
The net profit ratio is also known as the profit margin.