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.
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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:
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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 timeClick 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.
Frequently asked questions about net profit margin
The net profit margin equals net income (i.e. net profit after taxes) divided by sales. It’s usually expressed as a percentage.
A good profit margin will depend on many factors—your sector, company size and region. Benchmarking tools can help you see how your net profit margin compares against industry peers. Anything above the industry average is good; below average means you may need to analyze why you’re underperforming.
Various factors may be involved such as:
- you increased prices
- higher volumes let you reduce unit costs for each sale
- a competitor closed its business
Frequent causes for a decline in net profit margin include:
- raw material costs went up
- efficiency has declined
- you reduced prices because of new competition
- Take time out to explore with your team ways to get leaner, areas of wasted resources or effort and structured ways to solve bottlenecks and other chronic business challenges.
- Bring in an external expert to help you improve your operational efficiency.
- Review your business model using a business model canvas.
- Develop a strategic plan to set business goals (such as improving profitability) and a roadmap for getting there.
In addition to the steps above, you can consider the following.
- Carefully review your finances to identify the reasons for the loss and whether it’s a one-time occurrence or a longer-term trend.
- Prepare financial forecasts to determine your cash flow needs and possibly initiate discussions with lenders or others to address financing gaps.
- Take a look at your cost structure.
- Consider bringing in an outside expert to help you understand the reasons for the loss and possible solutions.
Gross profit margin (sometimes called the gross margin) is the gross profit (i.e. sales minus direct costs, a.k.a. cost of goods sold) divided by sales. This is the profit available to cover general, sales and administrative expenses, depreciation, amortization, interest and taxes. Unlike net profit margin, it doesn’t include operating expenses, depreciation, amortization, interest, non-operating income and expenses, or income taxes.
Download our free guide Monitoring Your Business Performance for more information on key ratios for managing your business.