Saturday, February 15, 2020

Net Profit Margin

What Is Net Profit Margin?

The net profit margin is equal to how much net income or profit is generated as a percentage of revenue. Net profit margin is the ratio of net profits to revenues for a company or business segment. Net profit margin is typically expressed as a percentage but can also be represented in decimal form. The net profit margin illustrates how much of each dollar in revenue collected by a company translates into profit.

Net income is also called the bottom line for a company or the net profit. Net profit margin is also called net margin. The term net profits is equivalent to net income on the income statement, and one can use the terms interchangeably.

Calculation for Net Profit Margin

  • On the income statement, subtract the cost of goods sold, operating expenses, other expenses, interest (on debt), and taxes from revenue.
  • Divide the result by revenue.
  • Convert the figure to a percentage by multiplying it by 100.
  • Alternatively, locate net income from the bottom line of the income statement and divide the figure by revenue. Convert the figure to a percentage by multiplying it by 100.

What Does Net Profit Margin Tell You?

The net profit margin factors in all business activities including:
  • Total revenue
  • All outgoing cash flow
  • Additional income streams
  • COGS or cost of goods sold and other operational expenses
  • Debt payments including interest paid
  • Investment income and income from secondary operations 
  • One-time payments for unusual events such as lawsuits and taxes
Net profit margin is one of the most important indicators of a company's financial health. By tracking increases and decreases in its net profit margin, a company can assess whether current practices are working and forecast profits based on revenues. Because companies express net profit margin as a percentage rather than a dollar amount, it is possible to compare the profitability of two or more businesses regardless of size.

Investors can assess if a company's management is generating enough profit from its sales and whether operating costs and overhead costs are being contained. For example, a company can have growing revenue, but if its operating costs are increasing at a faster rate than revenue, its net profit margin will shrink. Ideally, investors want to see a track record of expanding margins meaning that net profit margin is rising over time.

Most publicly traded companies report their net profit margins both quarterly during earnings releases and in their annual reports. Companies that can expand their net margins over time are generally rewarded with share price growth, as share price growth is typically highly correlated earnings growth.

Net vs. Gross Profit Margin

Gross profit margin is the proportion of money left over from revenues after accounting for the cost of goods sold (COGS). COGS are raw materials and expenses associated directly with the creation of the company's primary product, not including overhead costs such as rent, utilities, freight, or payroll.

Gross profit margin is the gross profit divided by total revenue and is the percentage of income retained as profit after accounting for the cost of goods. Gross margin is helpful in determining how much profit is generated from the production of a company's goods because it excludes other items such as overhead from the corporate office, taxes, and interest on a debt.

Net profit margin is the percentage of profit generated from revenue after accounting for all expenses, costs, and cash flow items.

Limitations of Net Profit Margin

Net profit margin can be influenced by one-off items like the sale of an asset, which would temporarily boost profits. Net profit margin doesn't hone in on sales or revenue growth, nor does it provide insight as to whether management is managing its production costs.

It's best to utilize several ratios and financial metrics when analyzing a company. Net profit margin is typically used in financial analysis, along with gross profit margin and operating profit margin.

Hypothetical Example

Imagine a company that has the following numbers reported on its income statement:

  • Revenue: $100,000
  • Operating costs: $20,000
  • COGS or cost of goods sold: $10,000
  • Tax liability: $14,000
  • Net profits: $56,000
Net profit margin is thus 0.56 or 56% ($56,000/$100,000) x 100. A 56 percent profit margin indicates the company earns 56 cents in profit for every dollar it collects.

Let's take another hypothetical example using the made-up Jazz Music Shop's FY 2025 income statement.

Here, we can gather all of the information we need to plug into the net profit margin equation. We take our total revenue of $6,400 and deduct variable costs of $1,700 as well as fixed costs of $350 to arrive at a net income of $4,350 for the period. If Jazz Music Shop also had to pay interest and taxes, that too would have been deducted from revenues.

Real World Example

Below is a portion of the income statement for Apple Inc. (AAPL) as reported for the quarter ending on December 29, 2018:

  • Net sales or revenue was $84.310 billion (highlighted in blue).
  • Net income was $19.965 billion for the period (highlighted in green). 
  • Apple's net profit margin is calculated by dividing its net income of $19.965 billion by its total net sales of $84.310 billion. Total net sales are used as the top line for companies that have experience customer returns of their merchandise, which are deducted from total revenue.
  • Apple's net profit margin was 23% or ($19.965 billion ÷ $84.310 billion) x 100.

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