Net Profit Margin | Definition | Formula

Profit Margin

Understanding profit and profit margins is crucial to the ultimate goal of business owners and decision makers – to earn the money they need to be successful and grow their company.

What is Profit?

In short, profit is the amount of money a company has after subtracting the money it spends on the operation. It’s the financial measure of a company’s performance. After every business expense is recorded over a specific period, profit is the cash that is remaining.

What is Revenue?

Revenue is the total amount of cash that a company takes in during its business process. While revenue represents all income, profit is a key figure in a financial statement, because it demonstrates what money remains for the company after all its bills are settled. That is why revenues alone cannot be used to accurately measure financial performance.

Profit Margin Formula

The formula to determine profit margin is net income divided by net sales. Net sales include gross sales minus discounts, returns, and allowances. Net income is the total revenue minus expenses.

The profit margin is at the heart of your business’s success. It demonstrates the percentage of your revenue that is actual earnings, as compared to company costs and expenses. Profit margins in business finance tell you how much you make on every product or service.

While it seems logical, small business owners often either don’t understand or forget about profit margins, including what their profit margin objectives should be. You can use our useful guide to evaluate your small business’s profit margin goals below.

Importance of Profit Margin

These are some reasons why your profit margins should be tracked:

  • It helps you to grow your business: Figuring out profit margins can help you determine excess costs and the performance of your business products and practices. It is useful to know how your business is progressing as it grows and expands.
  • It’s necessary for financing: You may have an impressive product, concept or service, but lenders want to understand what your profit margin is before they offer you small business credit. Even if you make millions already, it is harder to secure financing if you don’t know whether your company is solvent.
  • It enables you to solve problems: Staying tuned to your profit margin enables you to identify problems that your company might be having. For example, you may have some pricing mistakes, cost management problems or accounting issues if your profit margin is small.

If you have a profit margin, you can see that you are actually earning money after your company expenses are covered. You can also see from the profit margin if your items or services are too costly or underpriced.

What is the Profit Margin Formula?

Most organizations use the following formula to calculate a company’s profit margin:

Profit Margin = (Net Income/Net Sales) * 100

Net income is the total revenue minus business expenses. Net sales is gross sales minus discounts, allowances, and returns.

Understanding the Net Profit Margin Ratio

The net profit margin ratio is used to describe a company’s ability to generate profit and account for a variety of scenarios, such as an ineffective increase in expenses. It’s widely used in financial modelling and business valuation.

Net profit margin, which is usually expressed as a percentage, is a strong indicator of a company’s overall success. Keep in mind, however, that a single number in a company report is rarely sufficient to indicate overall company performance. An increase in revenue may result in a loss if it is followed by an increase in expenses. On the other hand, a decrease in revenue, followed by tight control over expenses, could push the company even further into profit.

A high net profit margin means that a company can effectively control its costs and/or provide goods or services at a price that is significantly higher than its costs. As a result, a high ratio can result from:

  • Efficient management
  • Low costs (expenses)
  • Strong pricing strategies

A low net profit margin indicates that a company has an inefficient cost structure and/or poor pricing strategies. As a result, a low ratio can result from:

  • Inefficient management
  • High costs (expenses)
  • Weak pricing strategies

Investors should use the profit margin ratio as an overall indicator of a company’s profitability performance, and then conduct additional research into the causes of an increase or decrease in profitability as needed.

Limitations of Net Profit Margin Ratio

Analysts frequently compare the net profit margin ratio of different companies to determine which business performs the best.

While this is common practice, the net profit margin ratio of companies in different industries can vary greatly. Companies in the automotive industry, for example, may have a higher profit margin ratio but lower revenue than companies in the food industry. A food company may have a lower profit margin ratio but higher revenue. Only companies in the same sector with similar business models should be compared.

Other limitations include the possibility of interpreting profit margin ratio and cash flow figures incorrectly. A low net profit margin does not always indicate that a company is doing poorly. Furthermore, a high net profit margin does not always imply a high cash flow.

Net Profit Calculation Example

Company X and Company Y have net profit margins of 12% and 15% respectively. Each company earned $150 in revenue. How much net profit did each company make?

Step 1: Write out formula

Net Profit Margin = Net Profit/Revenue

Net Profit = Net Margin * Revenue

Step 2: Calculate net profit for each company

Company X:

Net Profit = Net Margin * Revenue = 12% * $150 = $18

Company Y:

Net Profit = Net Margin * Revenue = 15% * $150 = $22.50

See Also

How to calculate business startup costs