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.