What is Net Profit Margin?
When you’re checking out a business, the net profit margin is key — It’s the calculation used to determine the percentage of profit a company earns out of its total overall revenue.
The net profit margin is one of the essential calculations used to determine a company’s financial health — it’s the percentage of profit a company earns out of its total overall revenue. And it’s simple to calculate: divide net income by total revenue. Companies use profit margin to check their spending and track how much of an impact that has on their returns.
If you ever had a lemonade stand, you might understand net profit margins already. If you charged $1 per cup of lemonade sold, and you sold 20 cups, you made $20. But the lemons, sugar, and cups altogether cost you $8. So what’s your profit margin?
$20 total sales - $8 cost of goods sold = $12 net income or profit. $12 net sales / $20 total sales = 0.6 x 100. A 60% profit margin. Nice job!
Every business has a “CODB” or cost of doing business. If costs become too unruly or if a business owner does not keep track, it can start to cost more to do business than the business actually earns. That said, there is a helpful way to instantly know whether a business is making the most money possible for the number of resources invested in the product or service. This snapshot is a ratio called net profit margin. This instantly tells a business owner whether they need to lower costs, increase revenue, or relax and enjoy some wiggle room.
A net margin is easily calculated after looking at an income statement, or a report that shows the total revenue streams and amounts for the period. Total revenue is the total amount earned or generated, whereas net income is what is left over after accounting for a business’s operating expenses.
You should care about net margins if you are a business owner or simply researching a business to invest in. You can learn about a company’s net profit margin by looking up its financial statements. Understanding net profit margin helps you understand whether a company is currently profiting or not, and to what extent. Profit margins are a great measurement of past performance, but they don’t actually predict future success.
Net profit margin also helps investors and shareholders gain a solid understanding of how efficiently a company is spending its money.
Let’s break profit margin down a little further. There are actually two different kinds of profit margins: net and gross. Gross profit margin refers to the sale of a good, and it’s the money left over from the cost of the goods sold, or COGS for short. COGS only looks at the costs going into the actual product being sold, not the overhead like rent, taxes, and insurance.
For a retail business, COGS includes the cost of the inventory that was sold, but net profit takes into account the cost of the goods, plus operating expenses. Operating expenses include the cost for things like shelving space, labor, technology, insurance, and fees.
Net profit margin takes things a step further and accounts for all expenses, costs, and cash flow items. This can be great in seeing an overall snapshot of a business. However, it can paint an inaccurate picture of the company when there are one-off cash flow changes like the sale of a big asset or the purchasing of new equipment. In this case, even these items would go into calculating the net profit margin.
Let’s jump into our lemonade example again:– COGS includes the lemons, the cups, and the sugar. And net profit margin would take the cost of the table plus paper and markers used for your sign.
Bottom line: Gross profit margins refer to the costs and revenue associated with a single product or products. Net profit margin looks at the health of the entire business, assets, and all.
There’s no gold standard when it comes to what makes a good profit margin. Some people say that healthy businesses have a profit margin between 10%-20%, but this is not necessarily true. It all depends on industry, demand, and what market a business is operating in. To get an idea of what profit margin a business should aim for, it’s best to look at its competitors’ performance and industry trends.
The most important consideration is this – Is the business not leaving money on the table by charging too little or spending too much? And, at the same time, is the business investing an appropriate amount of money into the product or service to ensure care and quality? At the end of the day, this is what’s important when it comes to profit margin.
Here’s the simple formula for calculating net profit margin: Net Income / Revenue = Net Profit Margin. A person can find net income and revenue numbers by looking at a public company’s income statement. This is a helpful tool for someone interested in investing in a company.
For example, someone interested in investing in Nike could look at the company’s income statement to see how its gross and net profit margins have changed over the years. In 2014, Nike earned a 44.77% gross net profit margin, which translated to a 9.69% net profit margin. While its gross net profit margin has remained stable with some ups and downs since then, its net profit margins have increased overall by just under 1%.
Source: Nike, Inc. Annual Reports 2014 – 2019
Businesses, like people, have to make hard decisions sometimes, and there are a few situations that can reduce net profit margin. This could be part of a business’s long-term strategy, and sometimes temporary growing pains are part of the process. That’s why keeping an eye on net profit margin is so important. A business should almost always aim to at least break even, or earn enough revenue to cover its expenses. But other times, there are reasons why a net profit margin can decrease.
For starters, financing a business with debt is one way to decrease net profit margins temporarily. For example, many companies have a line of credit established with a bank. This way, if there is a lag in cash flow coming in, it can use this line of credit to pay bills and cover payroll. But the thing about debt is that it must be paid back. If a business uses a line of credit to cover a month’s expenses, then, all things being equal, the net profit for the following month will be lower since the interest on the loan would add to a business’s overhead. Keep in mind – any increase in expense or reduction in revenue will ultimately affect the net profit margin.
For people interested in investing in a business, it’s worth noting when a business has a habit of relying on debt financing to take care of its CODB.
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