There are many ways to measure the profitability of a business. A key metric is net profit margin, which quantifies the revenue a business keeps after paying all of its expenses.
We’ll take a closer look at this measure of profitability by exploring:
- What is the net profit margin?
- How to calculate the net profit margin.
- How to use the net profit margin to value a business.
- What are the limits of the net profit margin?
What is the net profit margin?
Net profit margin, also known as net profit margin or net margin, is the ratio of the profit made by a business or business unit to the total amount of revenue (net sales) generated by the business or business unit. The net profit margin is expressed as a percentage. Net income is what is left after accounting for all expenses, including operating costs, interest, and taxes. In a nutshell, net margin is the percentage of a company’s turnover that it keeps as profit.
Calculating a company’s net profit margin helps investors assess the relative amount of profit the company derives from its income. A key indicator of overall financial health, net margin is also a great indicator to use when comparing a business with its competition. This metric can indicate whether a business is doing comparatively better or worse at controlling spending.
How to calculate net profit margin
Calculating a company’s net profit margin for a given reporting period is relatively straightforward. The net profit margin is equal to the net profit of a business – either shown as such in its financial statement or can be calculated as income minus cost of goods sold, operating and other expenses, interest and taxes – divided by income. This result is multiplied by 100 to convert the net margin ratio to a percentage.
Here is the formula for net profit margin:
Let’s say a business generates $ 1 billion in sales and $ 225 million in net income in a reference period. The company’s net margin is equal to its net income ($ 225 million) divided by its revenue ($ 1 billion). Multiplying this result by 100 yields a value of 22.5% for the company’s net profit margin.
It should be noted that the net margin can be positive or negative. A negative net profit margin means that the company or business unit was not profitable during the reference period.
How to use net profit margin to value a business
Net margin can help investors compare a company’s performance over multiple reporting periods and among its competitors. If a company undertakes a strategic initiative to increase profitability, investors can calculate the net profit margin to assess whether that initiative is working. If the company’s net margin is declining, investors can use this information to recognize deteriorating financial health.
A company with a higher net profit margin than its peers converts revenue into profit more efficiently. If a company’s net margin is lower than that of its industry peers, it could be a sign that it is financially weaker or less efficient than its competitors.
What are the limits of the net profit margin?
While net profit margin is a useful measure, it has some limitations. For example, it is not a good indicator for comparing companies from different industries. This is because in some industries single-digit net profit margins are considered quite good, while in other industries double-digit net profit margins are the norm.
Another limitation of measuring net margin is that it can vary significantly from one reporting period to another due to the potentially disproportionate effects of one-off events. Sales of assets can temporarily increase income, inflating net margin. Likewise, one-time expenses can weigh heavily on a company’s profitability for a reporting period. For this reason, it is important to understand the factors that influence net income over a given period in order to determine whether the net margin calculation is appropriate for valuing the business.
Net profit margin is just one of many metrics investors can use to analyze a business, and it’s certainly not the only metric that determines the value of an investment in stocks.
Net profit margin is an important measure of profitability
Investors can calculate net profit margin to understand how well a business converts income into net income. Additionally, despite its limitations, net profit margin is a good benchmark measure to measure whether a strategic initiative improves profitability or whether a company is more successful in generating a net profit than its peers.