What is Net Profit Margin?

When a person thinks of doing business, he first thinks about how much profit he will get from the business. Let us take a scenario of a shoemaker. 

A shoemaker manufactures and sells shoes as his business. The amount received from shoes sold is his sales, revenue, or income, but it is not what he takes home at the end of the day. 

Out of the money received from the shoes sold, he will have to pay for the raw material purchased, the rent of the facility in which the shoes are made, wages of the labourers who made the shoes, electricity bill, maintenance expenditures of the machines used, and other numerous expenses. After these expenses are paid, he will take the balance of money home in the form of profit earned. 

But, can an investor use a similar analysis to analyse the profitability of a company in which he is invested or is interested in investing?

Of course, YASS!!

The ratio which helps with this analysis is called the Net Profit Margin or the Net Profit Ratio.

So, let us understand more about this ratio, its calculation, interpretation, limitations etc. in my today’s blog “What is Net Profit Margin?”

In simple words, profit is nothing but the difference between a business’ receipts and expenses. To assess the profit-generating ability of a business, we shall calculate the profit earned as a percentage of sales i.e., profit/sales * 100 which is also called the Net profit Margin.

It is an important indicator of a company’s overall financial health. It helps the investors to assess the management’s ability to generate profit after considering both the direct and indirect expenses.

While calculating the Net profit margin, operating expenses like material cost, manufacturing cost, and employee costs, as well as non-operating expenses like depreciation, amortization, interest, and tax, are considered.

The formula for calculating Net Profit Margin is:

Net Profit Margin = Net Income / Revenue *100

Here, Net Income is simply the profit earned for the period i.e., all incomes less all the expenses.

Let us understand this by way of an example

. 

Here, the net Profit margin (NPM) of ABC Company Limited is:- 

Net Profit Margin = Net Income / Revenue * 100

= 1,56,000/10,00,000*100 

= 15.60%

This means for every Rs.100 revenue earned, ABC Company Limited is generating a profit of Rs.15.60.

Now this percentage can be compared with the company’s previous year’s percentage to see if the profitability has increased or decreased. Similarly, it can be compared with another company’s net profit margin in the same industry. Generally, an increase in the ratio indicates a positive sign.

The net profit ratio is undoubtedly a vital metric in evaluating a company's financial health, yet it comes with its own set of limitations that are crucial to understand.

Businesses with substantial property, plant, and equipment (PP&E) may encounter higher depreciation expenses, thereby reducing their net profit margin. This scenario can be deceptive as it may obscure a company's strong cash flow, making it appear less competitive due to the lower profit margin. Additionally, management may opt to curtail long-term expenditures, such as research and development, to artificially inflate short-term profits. This strategy can mislead investors who solely rely on net margin analysis. 

Therefore, the net profit margin should not be evaluated in isolation but can be used in combination with other profitability ratios for an accurate assessment of any company's financial performance.

But what are the other profitability ratios? How to compute them? And how to apply them?

Don’t worry, all the ratios will be covered in my upcoming blogs.

Till then take care, Jai Hind, and bye-bye!!!