Calculating net profit margin

Net profit margin is calculated by taking after-tax net profit and dividing by net sales. The formula set out below is the one typically used in most finance textbooks.

\(\mathrm{Net\: profit\:margin}=\mathrm{\frac{net\: income}{net \: sales }} \times{100\%}\)

Net sales may also be referred to as sales, sales revenue or net revenue.

Some financial analysts will additionally incorporate minority interest into the calculation, in order to provide a snapshot of the given company’s profitability prior to payments made to minority owners.

In the above example, company ABC averaged a profit margin of 10.44% over the past two financial years, which is the equivalent of saying that for every yen of net sales in that period the company generated a net profit of ¥0.140. As the figures show, the company made more profit per yen of expenses in 2012 than it did in 2011. This fluctuation could potentially be explained with reference to a range of active factors: for example procurement costs, increased prices for the company’s products or services, and efficiency improvements. Alternatively, the changes could be the result of market-based factors, such as falling commodity prices.

Profit margins inevitably vary by industry. However, when two companies are competing in the same sector against one another the sum can be particularly useful to determine which company is performing best and, therefore, represents a better investment opportunity. Let us suppose that both of the companies in the above example are software developers based in Japan. Over the period 2011-12, company XYZ averaged a net profit margin of 8.89% compared to company ABC’s 10.44%. So despite generating less sales revenue during the two-year period than company XYZ, company ABC may, according to the net profit ratio, represent a higher quality investment.

The above comparison, however, could provide a misleading benchmark if it is not compared to the industry average. For example, if the industry average for a Japanese software developer is an 18%, net profit margin, then it would seem that neither company has performed as well as their industry competitors over the two-year period.