What is net profit margin and how is it calculated?

Revolut Contributor

 · June 24, 2020  · 06/24/2020

Net profit margin is a ratio that reveals how much profit a business makes for every pound it generates in revenue over a given period, once all of its allowable costs are subtracted. These include costs that directly relate to sales – for instance, raw materials – and indirect ones, such as rent. Less obvious indirect costs are the allowances made for depreciation in the value of long-term assets and the interest owed on bank loans.

In the UK, there is ambiguity around the concept of “net profit” because it isn’t defined by the Financial Reporting Standard (i.e. FRS102). However, it’s generally understood to mean the profits of a business for a given period after deducting all expenses, including tax. This is the same as the US, where it’s the final figure on an income statement.

For UK businesses, there are situations when the phrase net profit refers to the profit before tax is removed. This point is always worth checking unless a precise description is provided.  We look at what this idea in more detail in our article about the net profit formula.

What is the net profit margin formula?

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 revenue during that time. The result is a ratio, which is then multiplied by one hundred to express the net profit margin as a percentage. If the business made a loss, the result would be a negative number.

Net Profit Margin (%) = (Net Profit / Revenue) x 100

The main complication with the net profit margin definition is that people describe its terms using different words. For instance, revenue is 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, with a worked example of how to calculate this here, and explore how it differs to gross profit here.  

What does net profit margin reveal about a business?

Let's look at an example. Avocado Ltd is a fictional business that makes and sells fruit-shaped furniture in London. In year one, its net profit margin was 25%, based on a net profit of £25k and revenue of £100k. These figures reveal that for every pound Avocado Ltd took in revenue, the business made 25 pence in profit before it deducted allowable costs.

YEAR ONE

Net Profit Margin (%) = (£25k / £100k) x 100 = 25%

In year two, Avocado Ltd made a net profit of £30k based on twice the amount of revenue. Naturally, the business is keen to present this as a success. The trouble is, smart investors will notice that even though the absolute level of net profit and revenue both increased, the net profit margin fell to 15% because the ratio of net profit to revenue dropped.

YEAR TWO

Net profit margin (%) = (£30 / £200k) x100 = 15%

As with gross profit margin there are several possible reasons for this fall. For instance, the business might have bought a pricy short-term asset or agreed to a higher rent. The issue is whether Avocado Ltd provides a plausible explanation for the margin reduction.

What are the limitations of net profit margin?

Investors pay close attention to the net profit margin of a business because it is based on the net profit, which is a fundamental number. Also, given that the net profit margin is calculated as a percentage of total revenue, it is a handy way to compare businesses of different sizes.

Even so, it does have some limitations. For one thing, net profit is such a comprehensive calculation that it is less reflective of day-to-day factors that are in the control of business managers compared to the operating profit margin. The reason is that the net profit formula – and its profit margin – both include factors that more nuanced metrics do not.

Last, a business might have a strategy to deliberately adopt a low net profit margin to gain market share aggressively. There could well be a broader picture to consider.

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