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When you’re evaluating the financial health of your company, or a company that you’re interested in investing in, understanding the proportion of revenue that translates into profit is invaluable. That’s why it’s a good idea to have a solid grasp on the concept of the ‘net profit margin’. But what is net profit margin? Get the lowdown on the net profit margin formula, right here.
What is net profit margin?
Net profit margin is a financial ratio that you can use to calculate the percentage of profit that businesses produce from their total revenue. Put simply, it measures the amount of net profit per pound of revenue. Net profit margin is a great indicator of the financial health of a company, partly because it factors in all business activities. By tracking the rise and fall of your company’s net profit margin, you can tell what’s working, what isn’t, and forecast future profits based on revenues.
How to work out net profit margin
The net profit margin formula, in its simplest form, is as follows:
However, in order to use this net profit margin formula, you’ll need to know how to work out ‘net profit’. Fortunately, there’s a net profit formula that you can use:
Let’s look at an example to see how to work out net profit margin in the real world. Imagine Company A makes around £100,000 in sales. However, it cost £40,000 to produce the goods, while Company A also spent a total of £15,000 on operating costs, including taxes and interest. You could work out the net profit margin formula as follows:
Net Profit Margin = (100,000 – 40,000 – 15,000) / 100,000 = 0.45 x 100 = 45%
As you can see, Company A has a net profit margin of 45%, which means that 45% of the value of all their sales is profit.
Net profit margin vs. gross profit margin
Gross profit margin and net profit margin measure slightly different things. Put simply, gross profit margin is the proportion of money left over from revenue after accounting for the cost of goods and services (COGS). However, unlike net profit margin, gross profit margin doesn’t account for operating expenses and other expenses, such as taxes and interest.
This is important, because gross profit margin may not give you the most accurate picture of your company’s profitability. For example, if your business’s revenues increase, you may be under the impression that profit is likely to increase as well. However, gross profit margin wouldn’t consider additional expenses, such as increased taxes, which could reduce the business’s overall profitability.
What are the limitations of the net profit margin formula?
Overall, the net profit margin formula is a good indicator of profitability. However, it’s important to remember that the net profit margin may be influenced by one-off sales, such as the sale of an asset, which make the business’s margins look deceptively healthy. In addition, if you’re using net profit margin to compare businesses, you should remember that companies in different industries have different business models and comparing net profit margin simply won’t tell the whole story.
It’s also worth remembering that net profit margin doesn’t give you any additional insight into sales/revenue growth, while it can’t help you understand whether production costs are being managed effectively. As always, it’s best to use net profit margin formula in concert with other financial metrics, such as gross profit margin or cash flow, to gain a better understanding of the company as a whole.
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