Net profit ratio
/What is the Net Profit Ratio?
The net profit percentage is the ratio of after-tax profits to net sales. It reveals the remaining profit after all costs of production, administration, and financing have been deducted from sales, and income taxes recognized. As such, it is one of the best measures of the overall results of a firm, especially when combined with an evaluation of how well it is using its working capital. The measure is commonly reported on a trend line, to judge performance over time. It is also used to compare the results of a business with its competitors.
Net profit is not an indicator of cash flows, since net profit incorporates a number of non-cash expenses, such as accrued expenses, amortization, and depreciation.
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How to Calculate the Net Profit Ratio
The formula for the net profit ratio is to divide net profit by net sales, and then multiply by 100. The formula is:
(Net profit ÷ Net sales) x 100
The measure could be modified for use by a nonprofit entity, if the change in net assets were to be used in the formula instead of net profit.
Example of the Net Profit Ratio
For example, the Ottoman Tile Company has $1,000,000 of sales in its most recent month, as well as sales returns of $40,000, a cost of goods sold (CGS) of $550,000, and administrative expenses of $360,000. The income tax rate is 35%. The calculation of its net profit percentage is:
$1,000,000 Sales - $40,000 Sales returns = $960,000 Net sales
$960,000 Net sales - $550,000 CGS - $360,000 Administrative = $50,000 Income before tax
$50,000 Income before tax x (1 - 0.35) = $32,500 Profit after tax
($32,500 profit after tax ÷ $960,000 Net sales) x 100 = 3.4% Net profit ratio
How to Improve the Net Profit Ratio
It can be difficult to improve a firm’s net profit ratio, since a business tends to pursue the highest-profit opportunities first, leaving lower-margin sales for later. A good way to avoid this trap is to pursue economies of scale, so that it becomes less expensive to generate each additional sale. This can be accomplished by engaging in bulk purchases in order to drive down the cost of materials per unit. Another option is to invest in product redesigns and automation in order to reduce the labor involved in product assembly. These actions will eventually reduce product costs, which improves the net profit ratio.
Problems with the Net Profit Ratio
There are several problems with the net profit ratio that you should be aware of before relying upon it. These issues are as follows:
Does not measure long-term profit-generating activities. The net profit ratio is really a short-term measurement, because it does not reveal a company's actions to maintain profitability over the long term, as may be indicated by the level of capital investment or expenditures for advertising, training, or research and development. Also, a company may delay a variety of discretionary expenses, such as maintenance, to make its net profit ratio look better than it normally is. Consequently, you should evaluate the net profit ratio alongside a variety of other metrics to gain a full picture of a company's ability to continue as a going concern.
Is not a true indicator of long-term profitability. A company may intentionally keep the net profit ratio low in accordance with a low-pricing strategy that aims to grab market share in exchange for low profitability. In such cases, it may be a mistake to assume that a company is doing poorly, when in fact it may own the bulk of the market share precisely because of its low margins. Conversely, the reverse strategy may result in a very high net profit ratio, but at the cost of only capturing a small market niche.
Could reflect tax minimization strategy. A company's owners may want to minimize income taxes, and so accelerate the recognition of taxable expenses into the current reporting period. This approach is most commonly found in a privately held business, where there is no need to impress outside investors with the results of operations.
Terms Similar to the Net Profit Ratio
The net profit ratio is also known as the profit margin.