Understanding and Using Net Profit Margin

Net profit margin is a metric used in financial analysis as a quick way to help determine the profitability of a company. The net profit margin can be calculated with two figures from the income statement: the top line (revenue) and the bottom line (net income). Net profit margin is defined to be the ratio of net income to revenue, expressed as a percentage. The mathematical equation is:

  • Net Profit Margin = (Net Income / Revenue) * 100 percent

Since net income is always less than revenue under normal circumstances, the highest theoretical net profit margin is 100 percent, but there is no maximum in the other direction. That is, any negative net profit margin is possible, and would represent the number of times that losses exceeded revenue in the period. Net profit margin is sometimes called profit margin, net margin or net profit ratio.

Profitability Ratios

As a profitability ratio, net profit margin indicates how well the company handles its selling strategies and cost management. In general, a higher selling price or quantity for the company’s goods will increase revenue, and if costs stay the same then net profit margin will increase, which is always better. As revenue increases, costs also tend to increase, so the amount of increased costs relative to the change in revenue determines whether net profit margin increases or decreases. If costs rise faster than revenue, net profit margin will decrease overall; and if costs rise slower than revenue, net profit margin will increase overall.

Other major profitability ratios are gross margin, return on assets, return on equity, and return on investment capital. In the case of gross margin, only the difference between revenue and direct costs (costs associated exclusively with producing the good or service) is used in place of net income. This can then be compared to net profit margin to see the impact of overhead, management salaries, interest costs, and taxes on the company’s profitability. If gross margin is very large, but net profit margin is very small, the company may need to move to a new facility or terminate some management positions to remedy the problem. The return classes are mainly used in determining how to best finance the company with a combination of stock and bond issuance.

Mechanics of Net Profit Margin

Since net profit margin is a single metric which considers only the percentage of revenue that net income represents, it is very difficult to make a substantial conclusion when comparing the net profit margin of different companies. All else equal, a higher net profit margin is more favorable, but a company with a lower net profit margin may still be a healthier and more stable company due to differences in pricing or cost structure.

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