What is Net Profit Margin
Net profit margin is a financial ratio that measures the operating effectiveness of management by comparing net income with net sales. The net profit margin expresses as a percentage to reflect the number of profits earned per dollar of sales.
To put it simply, the value of the net profit margin is the percentage of sales left after all company expenses such as marketing, product development, and other variable costs are deducted. For example, 25% of the company’s net profit margin means the company makes 25 cents per dollar of sales.
Normally, the net profit margin ratio is used to determine the operating effectiveness of the company’s management (the ability of a company to make money by managing costs). The higher value of the net profit margin shows the effectiveness of management. In contrast, the lower value of the net profit margin may be a result of the ineffectiveness of management.
Although it shows higher net income, the reality is that these differences are due to differences in non-operating factors, accounting methods, and other discretionary decisions, not that the company is necessarily outperforming comparable peers. For example, a company may have revenue growth, but if its operating expenses grow faster than revenue, its net income will decline. If investors think that net income will increase with net sales, that is an illusion; because there may be long-term expenses that will serve the company for a long time, and therefore may reduce net profit.
Be wary, different industries may have different bases value of the net profit margin values, this is the reason why you need to compare the net profit margin with rivals in the same industry.
Note: Net profit margin is also known as the Operating Margin and the Return on Sales.
Net Profit Margin Formula
Net profit margin can be calculated by dividing the net income (or EBIT) by the net sales, or as the following net profit margin formula:
NPM = (Net income / Net sales) x 100
For example, let’s say the Feriors company had the following financial results in the last accounting period:
- Net income of $20,000
- Net sales of $100,000
NPM = 20,000 / 100,000 = 20%
From the example, the 20% of net profit margin indicates the company makes 20 cents on each dollar of sales. Conversely, 80 cents of each dollar is its cost.
FAQs
Net profit margin is a financial ratio that measures the operating effectiveness of management by comparing net income with net sales as a percentage.
NPM = (Net income / Net sales) x 100
The higher value of the net profit margin shows the effectiveness of management.
