The business world is full of words that seem like synonyms. That’s because a lot of people use terms like revenue, income, profit, and earnings interchangeably. In reality, these words all mean different, important things—and it’s critical that any entrepreneur or small business owner understand them.
One of the most important things a business owner should understand is the extent to which their company is turning revenue (all money generated through day-to-day operations) into profit (revenue left over after business expenses are accounted for). The net profit margin helps you assess just how profitable your business really is.
What is net profit margin?
Net profit margin, sometimes known as just net margin, is the ratio of net income to revenue. Net profit margin measures your company’s net income, or profit, as a percentage of overall revenue.
Think of it this way: If your business generates $100,000 in revenue over the course of a year, and you spend $65,000 of that on overhead costs (like rent and utilities) and inventory, your profit is $35,000. That means that for every dollar you took in for the year, you kept 35¢ as profit—a 35% net profit margin.
Why is net profit margin important?
Net profit margin is one of the most important indicators of your business’s overall financial health. It’s critical for assessing whether your business is generating enough profit from sales, or whether materials and operating expenses are holding it back.
For instance, a company may have steadily increasing revenues over time. But if the cost of operating the business grows at a faster rate than revenue, net profit margin may decrease or even go into the negative, threatening the business’s financial survival. A negative net profit margin means that a business’s costs are exceeding its revenue for a given period.
Net profit margin also allows stakeholders to assess how profitable a company is over time. Ideally, net profit margins expand as a company matures and takes advantage of economies of scale.
How to calculate net profit margin
The net profit margin formula is net income divided by revenue, multiplied by 100. You can calculate your net income by taking your revenue and subtracting the following:
- Cost of goods sold (COGS). The direct costs of producing the goods or rendering the services sold by a business. It includes raw materials and production labor, but not indirect expenses like distribution costs and marketing costs.
- Operating expenses. Also known as overhead expenses, these are costs incurred while running the business that don’t go directly toward selling a product or service. It includes rent, insurance, salaries, legal fees, repairs and maintenance, utility payments—anything that keeps the lights on.
- Interest. Interest on any loans or lines of credit the business may hold.
- Taxes. Taxes including sales tax, income tax, and property tax.
All of the values that go into a net profit margin calculation can be found in a properly organized income statement.
As a written formula, net profit margin might look like:
Net profit margin = ([R – COGS – E – I – T] / R) x 100
Where R is revenue, COGS is cost of goods sold, E is operating and other expenses, I is interest, and T is taxes.
Net profit margin example
Let’s explore how net profit margin might be calculated based on a real-world example.
Say you run a specialty beauty supply shop online, and your revenue consists of what you make from selling shampoos, conditioners, styling products, and the like. You’ve recorded product sales of $75,000 on your company’s income statement.
Next, consider your COGS. Let’s say you’ve spent $20,000 on inventory. Then you have operating costs like rent ($20,000) and insurance ($7,500). Finally, let’s say you’ve paid $2,500 in interest payments on a small business loan, and you have a business income tax rate of 10% ($7,500).
With all of these values established, your formula for net profit margin would look like this:
([$75,000 – $20,000 – $20,000 – 7,500 – $2,500 – $7,500] / $75,000) x 100
Your store’s net income, or profit, is $17,500, which would give you a net profit margin of just over 23%. According to the Corporate Finance Institute, a good net profit margin is more than 10%—so it looks like your store is doing well.
Limitations of net profit margin
While net profit margin is an immensely useful tool for demonstrating profitability and understanding a company’s financial health, it’s not infallible.
One-off items in the income statement, like the sale of a large asset, can temporarily inflate profits, with no real change to business practices. Likewise, net profit margin doesn’t reveal much about total sales revenue, as the percentage could be inflated by low overhead.
It’s therefore best to use net profit margin as a piece of a broader financial picture when assessing your business’s health. You can leverage an array of ratios and financial metrics, including gross profit margin (which looks at profits after COGS) and operating profit margin (the ratio of operating income to net sales) to get a more complete picture of your business’s financial health.
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Net profit margin FAQ
What does a 5% net profit margin mean?
A 5% net profit margin means that for every dollar generated by a business, the company retains 5¢ as profit, after covering all expenses—COGS, operating expenses, interest, and taxes. A 5% net profit margin is generally considered low. A low net profit margin might mean that a business is buying too much inventory, paying too high a storefront rent, or using a poor pricing strategy.
What is a good net profit margin?
A 10% net profit margin is considered average, and a 20% profit margin is considered high. A higher net profit margin shows that a business is effectively managing its costs. However, a high net profit margin does not qualify the overall size of the company’s revenues or profits. Your business could earn $1, spend 25¢ on all costs, and come away with a 75% net profit margin. A fantastic figure! But your profits would only be 75¢.
How can I improve my net profit margin?
Businesses looking to increase their net profit margin should consider strategies that either increase revenue or decrease costs. The former could include raising prices, introducing new revenue streams, or engaging in promotions to bring in more customers. You could focus on cutting down COGS or operating expenses (or both) by more effectively managing inventory, buying materials at a better rate, or refinancing business loans.
What’s the difference between net profit margin and gross profit margin?
A company’s net profit margin represents its profitability after all COGS, operating expenses, interest, taxes, and other costs have been deducted from revenue. Gross profit margin shows a company’s profitability only after COGS has been deducted from revenue. Unlike net profit margin, which is a percentage, gross profit is an absolute dollar amount.