Thursday, 15 June 2017

Investopedia: What is 'Net Profit Margin'

Net Profit Margin

What is 'Net Profit Margin'

Net profit margin is the ratio of net profits to revenues for a company or business segment . Typically expressed as a percentage, net profit margins show how much of each dollar collected by a company as revenue translates into profit. The equation to calculate net profit margin is: net margin = net profit / revenue.

BREAKING DOWN 'Net Profit Margin'

Net margins vary from company to company, and certain ranges can be expected in certain industries, as similar business constraints exist in each distinct industry. Low profit margins don't necessarily equate to low profits. For example, Wal-Mart Stores Inc. has delivered high returns for its shareholders while operating on net margins less than 5% annually. In fact, in the first quarter of 2016, Walmart's profit margin was 2.66%. In contrast, a business with very small operating budget such as an independent contractor working as a freelance writer has a very small overhead and as a result, most of its revenue is tied to profits. However, although freelance writing may have a high profit margin, its annual profits may seem low when compared to a multinational corporation such as Walmart.

Most publicly traded companies report their net margins both quarterly during earnings releases and in their annual reports. Companies that are able to expand their net margins over time are generally rewarded with share price growth, as share price growth leads directly to higher levels of profitability.
How to Calculate Net Profit Margin?

To calculate net profit margin, find the company's revenue, which consists of all the sales, fees or other money the business has collected through the period. To ascertain profits, subtract operating expenses, cost of goods sold (COGS), interest and tax from revenue. If the business pays stock dividends, also subtract those payments from revenue when calculating profit, but do not take common stock dividends into account. Then, simply divide net profit by revenue, and to convert that number into a percent, multiply it by 100.

To illustrate, imagine a business has $100,000 in revenue, but it also has $20,000 in operating costs, $10,000 in COGS and $14,000 in tax liability. Its net profits are $56,000. Profits divided by revenue equals .56 or 56%. A 56% profit margin indicates the company earns 56 cents in profit for every dollar it collects.

The Importance of Net Profit Margins

Net profit margin is one of the most important indicators of a business's financial health. It can give a more accurate view of how profitable a business is than its cash flow, and by tracking increases and decreases in its net profit margin, a business can assess whether or not current practices are working. Additionally, because net profit margin is expressed as a percentage rather than a dollar amount, as net profit is, it makes it possible to compare the profitability of two or more businesses regardless of their differences in size. Finally, a business can use its net profit margin to forecast profits based on revenues.

Profit Margin

What is a 'Profit Margin'

Profit margin is part of a category of profitability ratios calculated as net income divided by revenue, or net profits divided by sales. Net income or net profit may be determined by subtracting all of a company’s expenses, including operating costs, material costs (including raw materials) and tax costs, from its total revenue. Profit margins are expressed as a percentage and, in effect, measure how much out of every dollar of sales a company actually keeps in earnings. A 20% profit margin, then, means the company has a net income of $0.20 for each dollar of total revenue earned.

While there are a few different kinds of profit margins, including “gross profit margin,” “operating margin,” (or "operating profit margin") “pretax profit margin” and “net margin” (or "net profit margin") the term “profit margin” is also often used simply to refer to net margin. The method of calculating profit margin when the term is used in this way can be represented with the following formula:

Profit Margin = Net Income / Net Sales (revenue)

Other types of profit margins have different ways of calculating net income so as to break down a company’s earnings in different ways and for different purposes.

See which online broker provides the income statement for different stocks in our Brokerage Review Center.

Profit margin is similar but distinct from the term “profit percentage,” which divides net profit on sales by the cost of goods sold to help determine the amount of profit a company makes on selling its goods, rather than the amount of profit a company is making relative to its total expenditures.

BREAKING DOWN 'Profit Margin'

Rarely can a company’s individual numbers (like revenue or expenditures) indicate much about the company’s profitability, and looking at the earnings of a company often doesn't tell the entire story. Increased earnings are good, but an increase does not mean that the profit margin of a company is improving. For example, suppose one year Company A’s revenue is $1 million and its total expenditures are $750,000, making its profit margin 25% ($1M - $0.75M / $1M = $0.25M / $1M = 0.25 = 25%). If during the following year its revenue increases to $1.25 million and its expenditures increase to $1 million, its profit margin is then 20% ($1.25M - $1M / $1.25M = $0.25M / $1.25M = 0.20 = 20%). Even though its revenue has increased, Company A’s profit margin has diminished because expenses have increased at a faster rate than revenue.
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After-Tax Profit Margin
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After-tax profit margin is a financial performance ratio, calculated by dividing net profit after taxes by revenue. A company's after-tax profit margin is important because it tells investors the percentage of money a company actually earns per dollar of revenue. For example, if someone owns a store and his net profit or net income after taxes is $100,000, and his net sales are $200,000, he has a 50% profit margin after taxes.
After-Tax Profit Margin
BREAKING DOWN 'After-Tax Profit Margin'
Often, a company's earnings don't tell the entire story. The amount of profit can increase, but that doesn't mean the company's profit margin is improving. For example, a company's sales could increase, but if costs also rise, that leads to a lower profit margin than the company had when it had lower profits. This is an indication that the company needs to better control its costs.

How Do After-Tax Profit Margins Work?

To illustrate, imagine that one year a company has $200,000 in net profit after taxes after collecting $300,000 in revenue, resulting in an after-tax profit margin of 66%. The following year, the company's net profit increases to $300,000, and it has $500,000 in revenue, yielding an after-tax profit margin of 60%. Although the company took in $200,000 more in revenue and had a $100,000 increase in profits, its margin shrunk. This means the company is making more money but also spending more for every dollar it earns.
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