Net profit ratio

10/06/2020 0 By indiafreenotes

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.

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, analysts commonly compare the figure to different companies to determine which business performs the best.

While this is common practice, the net profit margin ratio can greatly differ between companies in different industries. For example, companies in the automotive industry may report a high profit margin ratio but lower revenue as compared to a company in the food industry.  A company in the food industry may show a lower profit margin ratio, but higher revenue.

It is recommended to compare only companies in the same sector with similar business models.

Other limitations include the possibility of misinterpreting the profit margin ratio and cash flow figures. A low net profit margin does not always indicate a poorly performing company. Also, a high net profit margin does not necessarily translate to high cash flows.