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Net Profit Margin: Definition, Formula and Explanation

Sarmaaya Desk
Sarmaaya Content Team

Key Takeaways:

  1. The Net Profit margin is a ratio between the company’s profits against its revenues
  2. It talks about the percentage of revenue in the dollar amount is converted into profits
  3. A company can determine whether or not their current financial practices are working and can predict profits based on their revenues.
  4. Companies which are able to increase their net profit margins over time are usually given a return un the form increase in their share price
  5. It does not result in overall betterment of revenue or sales growth.

What is Net Profit Margin?

It is a ratio between the company’s profits against its revenues and it calculates how much profit is generated as a percentage of a company’s revenue. It talks about the dollar amount of revenue that is converted to profits. Also called the net margin, it is typically found in the income statement.

Calculating Net Profit Margin

Calculating it is fairly simple. You will find all the relevant figures required to do so in a company’s income statement. The formula used is as followed:

Net Profit Margin = (Net Profits / Revenue) x 100

The following example illustrates Company XYZ’s income statement. We will be calculating its Net Profit margin.

Net Profit Margin = (100,000/2,000,000) x 100

//    = 0.05 x 100

//    = 5%

Understanding

It serves as one of the vital indicators of any company’s financial situation. By keeping a check on the performance of its net profit margin, a company can determine whether or not their current financial practices are working and can predict profits based on their revenues. Since it is expressed as a percentage, financial analysts can use it in conjunction with other companies’ ratio to compare their profitability regardless of their size. It is used along the gross profit margin and operating profit margin. For better analysis and understanding, using multiple financial metrics and ratios can help analysts make better assessment and decisions.

Because of this, investors are more able to assess whether or not the company’s management is handling costs and if it is bringing in enough profits from their business activities. A company growing in revenue could still have a reducing it due to its unmanaged operating costs. It is preferred by analysts and investors to be able to see a steadily rising trend of net profit margin over time.

Companies which are able to increase their net profit margins over time are usually given a return the form increase in their share price because the share price is heavily impacted by the increase in earnings.

However, there are limitations to net profit margins. It can be influenced by the sale of an asset – which would temporarily result in an increase in profits. It however does not result in overall betterment of revenue or sales growth, nor does it provide any information regarding how the company’s management is handling production cost.

 




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