How to Calculate Net Profit Margin? Formula and Example

What Does Net Profit Mean?

The net profit margin is a term used to evaluate the actual profit a business generates from its revenue. It represents the relationship between a company’s net profit and its revenue. “Profit margin” or “net profit margin ratio” are its synonymical terms.

Key Points –

• Net profit is usually expressed in percentage form but it can be expressed in decimal form also.
• Business owners and investors use net profit margin to determine whether the company is generating satisfactory profit or not.
• Net profit is an indicator to measure a company’s financial health.

Why Is Net Profit Margin So Valuable?

Net profit margin is helpful in analyzing the real profit after all expenditures. This helps in assessing the level of profit a business achieves.

It also acts as an approval for the loan process. Whenever you take a business loan, the bank will check the financial status and other statements. A high profit margin acquiring business always gets the loan easily.

Tracking the net profit margin is also useful in making the decision. It helps to analyze whether the current practices are OK or if there is a need for introducing a change.

What Is the Process of Net Profit Margin Calculation?

Now let’s get an insight of the process to calculate net profit margin. While professionals may consider it a complex process, it is actually quite simple.

Here are the steps –

1. You must consider your gross revenue that will be mentioned on your income statement.
2. Now, subtract COGS or other applicable expenses, tax or interest from this gross revenue
3. By doing this, you will obtain a net income
4. Divide this net income by the revenue
5. To get its percentage form, multiply the output by 100.

The steps outlined above explain how to determine the net profit margin. Like this you can easily determine the net profit margin as a percentage. There is a need to consider tax, applicable expenses, and COGS of the company while calculating the net profit margin.

Net Profit Margin Formula

Here is the net margin formula through which you can easily calculate the net profit margin.

Net profit margin = ((R – COGS – E – I – T) / R ) x 100

= (Net income / R ) x 100

Here,

R = Revenue
COGS = Cost of Goods Sold
E = Expenses
I = Interest
T = Taxes

It simply states to subtract the Cost of Goods Sold, Expenses, Tax, and Interest from revenue. Now divide the outcome from the revenue and change it to percentage form.

Net Profit Margin Calculation Example

Let’s consider the net profit margin calculation example and understand it well. Suppose a company named ABC makes a revenue of $100,000, and the operating cost is $10,000. Here, $5,000 is a COGS and $12,000 is an applicable tax. Thus, according to the formula, the net profit margin will be as follows –

Net Revenue = Revenue – COGS – Operating cost – Tax
= $100,000 – $5,000 – $`0,000 – $12,000
= $73,000

Net Profit Margin = 73,000/100,000 * 100 = 73%

That is a company makes 73% of profit for every dollar.

We take another example of net profit margin that explains comparing the two companies. Suppose there are two companies named A and B. The income statements of both companies are as follows –

Company A

Revenue – $1,000
COGS – $20
Operating Expenses – $20
Interest Expense – $5
Tax expense – $20

Company B

Revenue – $1,000
COGS – $35
Operating Expenses – $40
Interest Expense – $5
Tax Expense – $50

Net income of company A = $1,000 – (20-20-5-20)
= $935

Net income of company B = $1,000 – (35-40-5-50)
= $870

Applying the formula of net profit margin –

Net income of company/ Revenue x 100

For company A –

935/1000 x 100 = 93.5%

For company B –

870/1000 x 100 = 87%

The above calculation shows that company A has a high net profit margin.

Net Profit Margin Ratio Limitations

The net profit margin ratio varies from company to company corresponding to the industry. For instance, a company in the pharmaceutical industry may have low revenue but a high profit margin as compared to a company in the automobile industry, where there can be high revenue but a low profit margin. Therefore, there should be comparisons between companies of the same industries.

There is often a misconception about low and high net profit margins. A low profit margin doesn’t need to always indicate poorly performing companies and a higher net profit margin always means higher funds.

Gross Profit Margin Versus Net Profit Margin

Often, it creates perplexing conditions, and professionals confuse it with gross profit margin and net profit margin. However, both are different in the following points.

Which Industries are Characterized by High or Low Profit Margins?

High profit margin industries produce sales without spending time on marketing, production, and overhead. With innovation, these industries benefit from acquiring high net profit margins.

Also, in the market, these industries always face low competition. Some companies at the initial stage face struggle and loss, but they earn high cash later on.

Examples: Software and technology companies, financial institutions, and healthcare

Lower profit margin industries face competition, uncertain consumer demands, and high operational costs. The companies in these industries are often involved in production with high expenses.

Examples: Automobile companies, transportation, manufacturing, and the construction industries.

Wrapping Up

Business owners must be aware of accounting concepts like net revenue, profit margin, etc. Calculating the net profit margin is necessary to track the financial health and overall company performance.

Knowing the correct procedure for determining the net profit margin is vital. Tracking the revenue and expenses helps in making crucial decisions.

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