Net Profit Margin Explanation

Sales are important to any company, but tracking sales revenue alone does not give a company clear insight into how they are doing financially. In order to determine their profit, companies must deduct expenses, bills and overhead from the sales revenue. The amount that remains is the company's net profit margin, and is a good indicator of their profitability and market viability.

What is Net Profit Margin

Net profit margin, sometimes called net margin, shows directly the amount of a company's net income in relation to the total sales earned. This ratio helps a company determine how much actual profit is made from each sale earned. The higher the net profit margin, the better the company is doing at turning sales into profit. Strong sales will increase the net profit margin; however, decreasing costs and overhead also help turn those sales into profit.

Applications of the Net Profit Margin

The net profit margin allows companies to determine how well they are doing in relation to other industries and competing companies; therefore, it is an integral part of business management. The higher the net margin ratio, the better the company is at managing costs and turning sales into profit. Investors and shareholders rely on the net profit margin to evaluate the worth of a company, and this affects the corporation's stock and overall image in the business world as well.

Calculating Net Profit Margin

To calculate the net profit margin, take the net income of a company and divide it by sales. For example, if a company has $50,000 in sales and $10,000 in net income, the net profit margin would be 20 percent. This means that 20 cents of net income comes from every dollar of sales. However, with larger companies this calculation can be complex as several sales divisions may exists and expenses may cross into various sales groups or areas.

Gross Profit Margin vs. Net Profit Margin

While net profit margin shows how much profit comes from sales, gross profit margin shows the profit a company makes on the cost of the sales. Gross profit margin shows how costs such as supplies, labor and production affect profits overall and is calculated by deducting the cost of goods sold from the sales revenue and then dividing the number by sales. Both gross and net profit margins are important as companies not only need to determine their overall profit, but how much they are able to spend on business operations and supplies.