What does net profit ratio mean and how is it calculated?
Net profit ratio reveals how much profit a business makes for every pound it generates in revenue over a given period, once it accounts for every allowable cost. This figure is nearly always changed into a percentage, as shown here, rather than expressed as a basic ratio.
The final percentage is then called the net profit margin or, sometimes, the net profit margin ratio. We cover the premise of what the net profit margin means in detail here.
How do you calculate the net profit ratio?
Take the figure for the net profit of a business over a given period – for instance, a quarter or a financial year – and divide this monetary value by the total revenue.
Net Profit Ratio = (Net Profit / Revenue)
Let's look at an example. Avocado Ltd is a fictional business that makes fruit-shaped furniture in London. Its net profit is £25k, and revenue is £100k, so the net profit ratio is 0.25.
Net Profit Ratio = (£25k / £100k) = 0.25
In reality, we rarely use the ratio in this format. It is almost always multiplied by one hundred to express this figure as a percentage. In other words, to convert it to the net profit margin.
Net Profit Margin (%)= (Net Profit / Revenue) x 100
Net Profit Margin (%) = (£25k / £100k) x 100 = 25%
The main complication here is that people tend to describe some terms in these definitions with different words. For instance, the revenue might be called total sales or turnover, and indirect costs are often known as the cost of sales or the cost of goods sold (COGS).
We take a deeper dive into net profit here and provide a worked example of how to calculate this along with the net profit margin. You can discover its relationship to gross profit here or learn about its sibling figure, gross profit margin here.
Why is net profit ratio used?
The above example reveals that for every pound Avocado Ltd took in revenue, the business made 25 pence in profit before it deducted allowable costs, including overheads. The net profit ratio signifies how effective the business is at turning its revenue into net profits.
Investors pay closer attention to the net profit ratio – and consequently, the net profit margin – than almost any other figure during the financial analysis of a business. That is because it is based on net profit, a number so fundamental that it is often called 'bottom-line profit'. Also, because this ratio (i.e. percentage) describes the relationship between net profit and revenue rather than its absolute monetary value, its a handy way to compare businesses of different sizes.
What does a low net profit ratio mean?
If this figure is low, it highlights that the business is inefficient at converting its revenue into net profits. If the ratio is a negative number, this indicates that the business made a net loss.
Once we calculate the net profit margin, it is easy to compare this to previous years, performance forecasts, or rival companies. But that does not mean it is an infallible guide to the health of the business. For instance, the business might have a long-term strategy to use a low net profit ratio to gain market share. We cover the limitations of margin analysis here.
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