The net profit margin formula (or profitability of sales) is a ratio that describes how much profit a company gets from its total revenue. It is a percentage of sales that is left after subtracting all operating expenses, taxes, interest and preferred stock dividends.
Net profit margin is a measure of how much profit a company can produce from its revenue. The higher the ratio, the more profit is extracted from sales. For example, a net profit margin of 10% means that a company gets $1 of net profit from each $10 of sales.
How to calculate net profit margin?
Net profit margin is calculated by dividing net profit by total revenue. This number should be multiplied by 100 to be expressed as a percentage.
Net\;profit\;margin = \frac{Net\;profit}{Total\;revenue}This ratio is usually calculated for a standard reporting period, such as year, quarter or month because all data is taken from the income statement.
Net profit is calculated by deducting all company’s expenses from its total revenue.
These expenses are: cost of sold goods, operating expenses (rent, salaries, utilities, etc.), interest expense and taxes.
Total revenue is all the money a company gets from selling its goods or services.
So, net profit is the actual company’s earnings, the amount of money that is left after a company sells more than it spends. Therefore, the higher the net profit, the better.
Net profit margin explained
As well as a lot of financial ratios, net profit margin should be compared:
- In time for the same company. By comparing
net profit margin in time, we can create a trend and look for positive or negative changes. - With other companies in the same industry. It allows comparing a given company with its competitors.
The increase in the net margin from year to year means that every dollar of the company’s revenue gives it more and more profit. Generally, it’s assumed that in the long term net profit margin should at least not decrease
Desirable net profit margin is different for each industry, but as a reference point, net profit margin over 10% is considered excellent.
Examples of net profit margin calculation
Example 1: Company X and Company Y operate in the same industry. Which company has a higher net profit margin?
| Company X income statement (in thousands) | Company Y income statement (in thousands) |
|---|---|
| Revenue $200 | Revenue $300 |
| Cost of sold goods $50 | Cost of sold goods $100 |
| Gross profit $150 | Gross profit $200 |
| Operating expenses $50 | Operating expenses $90 |
| Operating profit $100 | Operating profit $110 |
| Interest expense $30 | Interest expense $30 |
| Earnings before taxes $60 | Earnings before taxes $80 |
| Tax expense $20 | Tax expense $25 |
| Net income $40 | Net income $55 |
1. Net profit margin for company X
Net\;profit\;margin_{X} = \frac{\$40}{\$200} = 0.2 = 20\%2. Net profit margin for company Y
Net\;profit\;margin_{Y} = \frac{\$55}{\$300} = 0.18 = 18\%In this example, company X has a higher net profit margin, despite having less revenue and a lower net profit.
Example 2: Company ABC has:
- Total revenue of $100,000
- Cost of sold goods $30,000
- Operating expenses $40,000
- Interest expense $15,000
- Tax expense $10,000
What is its net profit margin?
The total expenses for company ABC is $95,000, which leaves a net profit of $5,000 from $100,000 revenue.
Net\;profit\;margin = \frac{\$5,000}{\$100,000} = 0.05 = 5\%ABC Company’s net profit margin is 5%.
Example 3: Company A has a net profit margin of 5.6%, company B has a net profit margin of 7.2%. Both companies have revenue of $250,000. How much net profit did company A and company B make?
First we can convert the net profit margin formula into a formula which can calculate the net profit.
Net\;profit\;margin = \frac{Net\;profit}{Total\;revenue}Net\;profit = Net\;profit\;margin \times Total\;revenueNext, we work out the profit for company A:
Net\;profit = \$250,000 x 0.056 = \$14,000And finally, we work out the net profit for company B:
Net\;profit = \$250,000 x 0.072 = \$18,000So now you should be able to calculate both net profit and the net profit margin by using these relatively simple formulas.