What Does Net Profit Margin Mean?

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In corporate finance, a company's net profit margin is a measure of profit relative to sales. Therefore, net profit margin is net income divided by total net sales. Expressed on a percentage basis, profits of different periods from various companies can be directly compared despite their different sizes of operations.

Purpose

  • Net profit margin is used to evaluate a company's profitability across all business lines, both operating and non-operating activities. A widening or narrowing in net profit margins over time should tell management how efficiently a company is using its resources for generating a given amount of sales. To influence net profit margins, managers may seek ways of increasing production for any fixed amount of inputs.

Elements

  • Two basic elements of net profit margin are sales and net income. While sales are a simple figure found in the first line of a company's income statement, net income is the result of multi-step calculations that take into account various costs associated with all company activities from operations and administration to anything non-operational. The largest cost component is normally the so-called cost of goods sold, the cost basis for gross profit. To arrive at operating income, accountants further deduct from gross profit administrative expenses, research and development costs, and depreciation and amortization charges. Any commercial activities that are not part of a company's main-line business are considered to be non-operational, such as financial investments. Non-operating expense is the last cost component before taxes are charged and paid to arrive at net income.

Losses

  • When losses are reported in the income statement, the line for net income becomes a negative number, sometimes shown in red and with brackets. The net profit margin as calculated is then in effect a loss margin -- the difference between sales and costs, the loss, divided by sales. A loss margin measures the degree of the losses relative to the sales.

Comparison

  • Net profit margins are closely related to other profitability measures such as gross margin and operating margin. While net profit margin measures the total profitability of a company, taking into consideration all company undertakings, including corporate tax liability, other profit margins assess profitability in specific areas. Gross margin is the percentage of gross profit, which equals to total sales minus cost of goods sold, on total sales. Operating margin is the percentage of operating income, which equals to gross profit further deducted by total operating expenses, on total sales.

Misrepresentation

  • Net profit margin and net income can be misleading as the figures do not directly reveal the composition behind the numbers. A low net profit margin or net income for a given period may not be caused by a lack of efficiency in running a company's business by management. For example, a change in depreciation policy to accelerate depreciation would increase depreciation charge and reduce net income and net profit margin. Any non-operational charges also influence net profit margin when the underlying profitability actually remains uncharged.

References

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