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Net Profit Margin: Definition and How to Calculate it

In the company's accounting activities, there are analysis of financial ratios such as net profit margin, gross profit margin, debt to equity ratio and so on. Each financial ratio is important to determine the company's ability to obtain profit from income (earning).

Financial ratios or profitability ratios such as net profit margin and gross profit margin can be used to show the amount of company profits. Therefore, net profit margin and gross profit margin can affect the company's financial statement records.

Net Profit Margin Definition

What is net profit margin? Net profit margin is the profitability ratio which states the profit from business operations as a percentage of net revenue or sales. It takes into account all the costs facing the business, not just the cost of goods sold. This ratio is calculated by comparing the company's profits with the total amount of money it generates

By knowing the net profit margin, we can measure how effectively the company operates. The bigger it is, the more productive the company's performance will be, which will increase the confidence of investors to invest in the company.

Net profit margin shows the percentage of net profit obtained from each sale. This makes the ratio bigger, assumed to be the greater the company's ability to earn high profits.

A simple example, if a company has a net profit margin of 20%, that means it keeps 200 for every 1000 sales revenue.

This ratio is used to give analysts an idea of the company's financial stability. Companies that make more profit per value from sales are more efficient. Efficiency makes firms more likely to survive when product lines don't meet expectations, or when periods of economic contraction hit the broader economy.

How to Calculate Net Profit Margin

Net income is calculated by subtracting all of the company's expenses from its total revenue. The result of calculating the profit margin is a percentage.

For example, a profit margin of 10% means that for every 100 dollars in revenue the company generates a net profit of 10 dollars. Revenue represents the total sales of the company in one period.

In simple terms this ratio can be calculated comparing net profit after tax with net sales income.

NET PROFIT MARGIN FORMULA:

Net Profit Margin = Net Profit (Net Income): Net Sales (Net Sales)

Example of Calculation

Based on the company's financial statements, ABC Corp as of December 31, 2021 has a Net Sales Revenue of USD 30,000,000,000 while the Net Profit after Tax (Net Profit) earned is USD 2,000,000,000.

From the data above, ABC Corp's net profit margin can be calculated, namely:

Net Profit Margin = Net Profit (net income after tax): Net Sales

= 2,000,000,000: 30,000,000,000

= 0.067

So, ABC Corp's net profit margin is 0.067 or a percent can be expressed as 6.7%.

Net Profit Margin Limitation

Debt financing or borrowing money to finance company operations can also reduce your net profit margin. If you decide to use debt financing for your business, you will see an increase in interest costs, which can steer your net profit margins to undesirable levels.

However, that doesn't mean that debt financing is the wrong step to take. Determining the quality of the net profit margin in a scenario like this often requires a deeper analysis of why debt is acquired, how it is used, and whether the debt-to-asset ratio is healthy.

Net profit margin can be used to compare performance effectively over different periods. However, it only reveals reliable results if there are no other changes in your spending.

Interpret the net profit margin of the business

Net profit margin can show how well a company turns its sales into profit. In other words, the percentage is calculated by the net profit margin equation to show the percentage of revenue as the profit that the company keeps.

Conversely, this ratio also shows the amount of revenue that is lost through expenses and expenses associated with your business. By knowing this value, you can find out whether the business is already running effectively, and still has to reduce expenses.

You need to do an in-depth analysis regarding the arrangement of expenses and income targets. For example, increasing the cost of producing a higher quality product can attract a fair number of customers. Ultimately, this is expected to increase net sales. On the other hand, increasing costs can also decrease net sales if they are too much. Moreover, these costs will be charged to customers in the form of a higher price.

If the customer decides that the price increase is not comparable to a higher quality product, revenue will fall. This is where it is important to have a deeper analysis of the net profit margin. The higher expenditure should be considered sufficiently proportional to the improvement in quality and with the potential to increase sales as well.