Net profit margin is the percentage of revenue left after all expenses have been deducted from sales. The measurement reveals the amount of profit that a business can extract from its total sales. The net sales part of the equation is gross sales minus all sales deductions, such as sales allowances. The formula is:
(Net profits ÷ Net sales) x 100 = Net profit margin
The net profit margin is intended to be a measure of the overall success of a business. A high net profit margin indicates that a business is pricing its products correctly and is exercising good cost control. It is useful for comparing the results of businesses within the same industry, since they are all subject to the same business environment and customer base, and may have approximately the same cost structures.
Generally, a net profit margin in excess of 10% is considered excellent, though it depends on the industry and the structure of the business. When used in concert with the gross profit margin, you can analyze the amount of total expenses associated with selling, general, and administrative expenses (which are located on the income statement between the gross margin and the net profit line items).
However, the net profit margin is subject to a variety of issues, which include:
Comparability. A low net profit margin in one industry, such as groceries, might be acceptable, because inventory turns over so quickly. Conversely, it may be necessary to earn a high net profit margin in other industries just in order to generate enough cash flow to buy fixed assets or fund working capital.
Leveraged situations. A company may prefer to grow with debt financing instead of equity financing, in which case it will incur significant interest expenses, which will drive down its net profit margin. Thus, a financing decision impacts the net profit margin.
Accounting compliance. A company may accrue revenue and expense items to be in compliance with various accounting standards, but this may give an incorrect picture of its cash flows. Thus, a large depreciation expense may result in a low net profit margin, even though cash flows are high.
Non-operating items. The net profit margin can be radically skewed by the presence of unusually large non-operating gains or losses. For example, a large gain on the sale of a division could create a large net profit margin, even though the operating results of the company are poor.
Short-term focus. Company management could deliberately cut back on those expenses that impair the ability of the business to compete over the long term, such as equipment maintenance, research and development, and marketing, in order to increase the net profit margin. These expenses are known as discretionary expenses.
Taxes. If a company can apply a net operating loss carryforward to its before-tax profits, it can record a larger net profit margin. Alternatively, management might attempt to accelerate the recognition of non-cash expenses in order to minimize the amount of tax liability that it must record in the current period. Thus, a specific tax-related scenario can significantly impact the margin.
Example of Net Profit Margin
ABC International has a net profit of $20,000 in its most recent month of operations. During that time, it had sales of $160,000. Thus, its net profit margin is:
($20,000 net profit ÷ $160,000 net sales) x 100 = 12.5% net profit margin
The net profit margin is also known as net margin.