Net profit margin is calculated to know how much net income or profit is generated by the company as a percentage of revenue for a period. It’s part of profitability ratios used by financial analysts to analyse a company’s income statement.
You can present net profit margin in decimal form instead of showing as a percentage of revenue.
If a financial analyst wants to know which of two companies are more profitable? Then profitability ratios such as operating margin, net profit margin can help by expressing profit relative to revenue.
Net profit margin can be calculated by dividing net profit by revenue.
Here is the formula:
Net profit / Revenue
Net profit = Revenue – cost of goods sold – expenses – interest – tax
Example: How net profit margin helps in financial analysis
To understand how net profit margin is used for decision making, let us take one small example.
Assume company XYZ limited has Rs 2,00,000 of net profit and Rs 40,00,000 of revenue. Net profit margin of XYZ limited is 5%.
Which is calculated as follows;
Net profit margin = net profit / revenue = (Rs 2,00,000 / Rs 40,00,000) * 100 = 5%
This means company XYZ limited earns Rs 5 for each Rs 100 of revenue.
Suppose company ABC limited has Rs 4,00,000 of net profit and Rs 120,00,000 of revenue. Net profit margin of ABC limited is 3.33%.
By applying above formula net profit margin of ABC Limited is calculated as follows;
Net profit margin = (Rs 4,00,000 / Rs 120,00,000) * 100 = 3.33%
Now you have a net profit margin for both companies. You can answer which company is more profitable in percentage terms.
Obviously, company XYZ limited is more profitable than ABC as it has a higher net profit margin of 5%. Company XYZ can convert 5% of revenue to profit. Even though company ABC limited has higher profit and revenue in absolute amounts, it’s less profitable than XYZ limited.
Remember, just because company XYZ has a higher net profit margin, it doesn’t mean you should invest in it. You are required to analyse further to find out why XYZ is more profitable and will it be able to grow with that net profit margin.
Many other factors should be taken into account before making an investment decision. Complete fundamental analysis of the company might help you for investment decisions.
If you search for financial ratios, you may find a number of different ratios explaining different things. You need not apply all the financial ratios available in the universe.
We have a bunch of widely used accepted financial ratios that can be used to analyse any financial statements.
Example 2: Net profit margin Analysis
XYZ Limited reported the following data for the year ended 31st March 2022:
|Fiscal year ended||Net Income in INR Crore|
|31st March 2020||3,422|
|31st March 2021||3,945|
|31st March 2022||4,343|
By looking at the net income figure of XYZ company, it is clear that the net income of the company has grown steadily over the 3 years period.
However, can you assess the growth in profitability? Let us look at the net profit margin for 3 years to assess the performance on profitability.
|Fiscal year ended||Net profit margin as a %|
|31st March 2020||5.99%|
|31st March 2021||6.38%|
|31st March 2022||6.18%|
The net profit margin as reported by the company indicates that profitability from financial year 2020 to 2021 has improved but deteriorated slightly from financial year 2021 to 2022. You need to further analyse what causes the decline in profitability.
If the decline is likely to persist, then it’s not a good investment right now. However, if the decline is temporary due to certain external factors which can later be resolved, then one can remain invested or take an investment decision after analysing other aspects of the company.
Why is net profit margin important?
The first thing financial analysts look at is the profitability of a company. They are interested to know how the company has performed during the period in comparison to other companies or industry.
Net profit margin perhaps is considered as the most important ratio to measure a company’s profitability. High net profit margin indicates that the company is able to retain a higher percentage of the revenue as profit.
What is a good net profit margin?
Many investors ask “what is a good net profit margin?”
Good profit margin varies from industry to industry. But as a general rule of thumb, a 5% net profit margin is considered as low, 10% profit margin is considered as average, and a 20% profit margin is considered as high.
Profit margin should be compared with the immediate competitor and industry standards to know whether the company is getting a good percentage as profit from its revenue.
How can a company improve its net profit margin?
Businesses can improve their net profit margin by increasing sales and reducing its expenses.
Here are few ways to improve sales or revenue of a company;
- Introducing new products and/or services.
- Increase the number of customers.
- Increase sales by connecting with your customers through social media.
- By using referral program
- Expand to the new domestic market.
- Evaluating and optimising your sales channels
- By improving the efficiency of your marketing activities.
- Changing your prices, terms, or conditions of billing.
Cost cutting can impact a company’s profitability. Here are few ways to cut down costs;
- Cut costs on raw material and optimise your resources.
- Maximise your employee skills.
- Make the most of your office space.
Net profit margin is typically used along with other financial ratios to understand the efficiency and financial position of a company.