Net profit margin

Net profit margin (also called the return on sales ratio) is a widely used profitability indicator that gauges your company’s financial health. It is the percentage of sales revenue you have left after deducting operating expenses, depreciation, amortization, interest, and income taxes.

Simply put, it is your after-tax profit generated by each sales dollar. The number tells you how profitable your business has been.

“The higher your net profit margin, the more money you put in your pocket,” says Nadine Jaillet, a Senior Account Manager at BDC.

It’s a tool to drive conversation. It should trigger questions and help you identify red flags sooner, so you’re working smarter.

How to calculate the net profit margin:

Formula

NET INCOME

NET SALES

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Example of a net profit margin calculation

The net profit margin calculation is simple. Take your net income and divide it by sales (or revenue, sometimes called the top line). For example if your sales are $1 million and your net income is $100,000, your net profit margin is 10%.

The figures are usually taken from a year-end income statement or notice of assessment from tax authorities. It’s also possible to make interim calculations through the year (for example, on a monthly basis) to monitor your financial performance provided you make the appropriate adjustments for depreciation, amortization, interest and taxes. In this case, the calculation would use an estimated tax amount.

Where to find the elements of the net profit margin on the income statement

Why is net profit margin important?

Net profit margin (like other financial ratios) has many important uses, notably:

  • gauging financial health
  • benchmarking against peers
  • informing bankers

1. Gauging financial health

The net profit margin helps you understand your company’s financial health, see how it is trending and identify areas to improve. “It’s a tool to drive conversation,” Jaillet says. “It should trigger questions and help you identify red flags sooner, so you’re working smart. It’s sometimes eye-opening for the company.”

A change in the net profit margin can prompt you to look at other elements of the income statement to see how they may have contributed, such as material costs or operating expenses.

“Look into the reasons in more detail,” Jaillet recommends. “Maybe you need to review your operational efficiency, or maybe your pricing or labour costs are higher compared to your industry trends. You can use the numbers to inspire discussion with your leadership team.”

A company with a higher profit margin than competitors is usually more efficient, flexible and able to take on new opportunities. 

Jaillet gives the example of a company whose top line rises from $1 to $2 million a year, while the bottom line stays at the same $100,000. In this case, net profit margin has fallen by half from 10% to 5%.

“The company is working harder and making less money,” Jaillet says. “The net profit margin has dropped drastically. Why? Maybe they added a new division or bought market share; was it the right move? The indicator is the jumping-off point for a conversation. You need to understand the story behind changes.”

Example of net profit margin over time

Example of net profit margin over time Click to enlarge

2. Benchmarking against peers

You can use the net profit margin to benchmark against industry peers. “If the industry average is 5 to 7%, anything above 7% is great, while below 5% probably means you have opportunities to improve your margin,” Jaillet says.

“A company with a higher profit margin than competitors is usually more efficient, flexible and able to take on new opportunities,” Jaillet says.

When benchmarking, it’s important to keep in mind that industry averages can vary greatly due to multiple factors, such as company size, region and industry. Also be sure you’re comparing the same numbers. Some benchmarking tools (such as Industry Canada’s Financial Performance Data tool) use income before taxes to calculate a profit margin.

3. Informing bankers

Bankers typically use the net profit margin to evaluate an entrepreneur’s request for financing and their capacity to take on and repay debt.

“We usually look at the net profit margin over the last three to five years to see how the company is doing and where it’s headed, as part of a review of a number of financial metrics,” Jaillet says.

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