Net profit margin also called net profit ratio or simply profit margin determines net profit generated by each dollar of revenue earned during the period. Higher net profit margin indicates that entity was able to cover all of its expenses and still left with portion of revenue which is in excess of total expenses.
Technically net profit margin is the percentage of sales revenue remaining after all the expenses related to administration, distribution, financing, taxation and any other expenses have been deducted from entity’s revenue. Net profit margin is usually calculated using this formula:
= Net profit / Sales
Another less common formula is:
= Net profit / Net sales
Both net profit and sales or net sales figure is taken from income statement. Entity’s net profit may have a different name on the income statement. One common term is profit after tax. Profit after tax is what remains of sales revenue after deducting expenses from continuing operations of entity.
Its up to the judgement of analyst if sales figure should be used or net sales figure is more suitable. Though net sales figure is preferred. Net sales is calculated as:
Net sales = Sales – sales return – discount allowed – sales allowance
Sales allowance is the value of units lost or damaged during shipment to customer and thus actually indicate lost revenue as customer will not pay for such goods even if invoiced.
Analysis and Interpretation
As net profit margin shares the same base as gross profit margin, both share majority of factors of analysis and interpretation. One important distinction however, is that gross profit has only cost of goods sold to be considered whereas net profit margin calculation involves every relevant expense. Therefore the scope of factors and variables that affect net profit calculation is much wider in case of net profit margin.
For net profit margin ratio to improve:
- either numerator i.e. net profit has to increase. This can be achieved by lowering expenditure related to cost of sales, selling & admin expenses, interest costs etc. Although cost of sales figure is usually the significant of all, lower other costs may help improve net profit drastically. For example, relieving entity’s profit from interest expense burden by paying off debts. Revamping sales and admin functions to increase efficiency and laying off redundant employees. Another major cost is employee benefit plan that must be thoroghly planned and require far sightedness which if not managed properly may result in low net profits even if entity has good gross profit margin.
- or denominator i.e. sales/net sales has to decrease. Though technically it may work but its not desirable unless and until it has a logical cause and effect that goes in favour of entity. As net profit calculation is dependent on sales revenue figure, reducing sales revenue will also reduce net profit. The only situation where it might work is when rate at which sales revenue reduces, the expenses reduces at a larger rate and only then net profit margin will improve.
One good example is when entity has made changes to its credit sales policy by making it stricter which eventually required less discounts allowed to customer, lowered provision for doubtful debts, smaller to no bad debts, lesser reliance on short term loans thus lower interest cost. In this case, it might be possible that even with reduced sales, entity manages to improve net profit margin.