Net profit ratio
A company’s net profit percentage may be calculated as the ratio of earnings after taxes to net sales. After all of the expenses of manufacturing, administration, and finance have been removed from sales and income taxes have been recorded, it indicates the leftover profit that was made. As such, it is one of the finest measurements of the overall outcomes of a company, particularly when paired with an assessment of how well the company is using its working capital. It is usual practise to report the metric using a trend line in order to evaluate performance over time. In addition to this, it is used to evaluate a company’s performance in relation to that of its rivals.
Due to the fact that net profit takes into account a variety of non-cash items, such as accrued expenses, amortisation, and depreciation, net profit is not an accurate predictor of cash flows.
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 after tax ÷ 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.
Significance and Interpretation:
Net profit (NP) ratio is a useful tool to measure the overall profitability of the business. A high ratio indicates the efficient management of the affairs of business.
There is no norm to interpret this ratio. To see whether the business is constantly improving its profitability or not, the analyst should compare the ratio with the previous years’ ratio, the industry’s average and the budgeted net profit ratio.
The use of net profit ratio in conjunction with the assets turnover ratio helps in ascertaining how profitably the assets have been used during the period.
A high net profit margin means that a company is able to effectively control its costs and/or provide goods or services at a price significantly higher than its costs. Therefore, a high ratio can result from:
- Efficient management
- Low costs (expenses)
- Strong pricing strategies
A low net profit margin means that a company uses an ineffective cost structure and/or poor pricing strategy. Therefore, a low ratio can result from:
- Inefficient management
- High costs (expenses)
- Weak pricing strategies
Investors need to take numbers from the profit margin ratio as an overall indicator of company profitability performance and initiate deeper research into the cause of an increase or decrease in the profitability as needed.
Limitations of Net Profit Margin Ratio
When calculating the net profit margin ratio, it is usual practise for analysts to compare the number to that of other businesses in order to identify which company operates more effectively.
Although this is a fairly standard procedure, the ratio of a company’s net profit to its revenue may be somewhat varied depending on the industry in which the business operates. A firm in the automobile sector, for instance, can have a high profit margin ratio but a lower revenue total when compared to a company operating in the food industry. It’s possible for a corporation to have a lower profit margin ratio but larger sales if it operates in the food sector.
It is advisable to only compare businesses operating in the same industry with operational models that are comparable.
There is also the danger of incorrectly interpreting the profit margin ratio and the cash flow data. These are two further drawbacks. It is not necessarily the case that a firm with bad performance would have a low net profit margin. Additionally, a high net profit margin does not always equate to substantial cash flows being generated by the business.