Business leaders rely on several key performance indicators (KPIs) to assess their financial performance. Among these is net profit margin, which can provide a quick snapshot of how much money you’re making and highlight areas that need improvement.
Here’s how to calculate your net profit margin, with some tips on how to improve.
What Is Net Profit Margin?
Net profit margin (sometimes simply referred to as “net margin”) is a measurement of your net income, expressed as a percentage (or decimal) of your total revenue.
Essentially, your net profit margin tells you how much of your revenue translates into profits. As such, a low net margin may indicate that a company is struggling to make sales or faces high overhead costs.
Why Is Net Profit Margin Important?
Because net profit margin is a measure of profitability, it’s one of the most important metrics for evaluating a company’s success. Here are just a few reasons why net profit margin is worth paying attention to.
Measuring Financial Success
A high net margin indicates how much of a company’s revenue goes to profits rather than meeting overhead costs or business contracts.
Investors, for example, might look at the net profit margin to determine whether a company is worth investing in, and stakeholders might use this information to determine whether operating costs are under control.
Competitive Analysis
Net profit margin is always expressed as a percentage or decimal, which makes it easier to compare data between companies.
CFOs and other managers often look at other companies in their industry and use their net margins to set benchmarks for their own companies or create new goals of outperforming their competitors based on net margin data.
Identifying Problems
Just as a high net profit margin indicates strong financial health, a low net profit margin can point to internal problems and challenges. For example, many entrepreneurs face rising costs due to inflation, which means that more of their revenue is diverted to operating expenses rather than profit.
A low net margin could also mean that your pricing model is too low to generate a meaningful profit. Either way, your net profit margin may serve as an early warning sign that you have challenges that need immediate attention.
Financial Forecasting
Once your company understands its net profit margin, you’ll be better equipped to forecast profits based on current revenue projections. That is, if you know how much revenue to expect, you can use your net profit margin to determine the percentage you’ll keep as profit.
How to Calculate Your Net Profit Margin
Many companies provide their net profit margin as part of an annual or quarterly report. Here’s how to calculate your net margin.
Net Profit Margin Formula
Your net profit margin is actually a simple calculation:
Net profit margin = (net revenue) / (total revenue)
To calculate your net revenue, you’ll need the following data:
- Revenue (R)
- Cost of goods sold (COGS)
- Operating and other expenses (E)
- Interest (I)
- Taxes (T)
You can then calculate your net revenue as follows:
Net revenue = R – COGS – E – I – T
Putting it all together, the full equation becomes:
Net profit margin = (R – COGS – E – I – T) / (R)
Again, “R” here always represents the total revenue.
Net Profit Margin Example
Here’s how the formula works in action.
Imagine your company has a total revenue of $75,000 for the quarter. Now imagine your other data is as follows:
- COGS = $20,000
- Operating expenses (E) = $15,000
- Interest (I) = $5,000
- Taxes = $20,000
We can plug these values into our formula, which would look like this:
Net profit margin = ($75,000 – $25,000 – $15,000 – $5,000 – $22,000) / ($75,000)
Net profit margin = $8,000 / $75,000
Net profit margin = 10.7%
What Is a “Good” Net Profit Margin?
According to a study from NYU, the average net profit margin is 7.7% across different industries. A healthy net profit margin therefore ranges between 5% and 10%, and anything over 10% is considered to be a strong net profit margin.
That said, a healthy net margin can vary between industries and even the stage of a company’s development. For instance, grocery stores typically have low profit margins and depend on high sales volume for sustainability.
How to Improve Your Net Profit Margin
To improve your net profit margin, you’ll either have to increase your sales or decrease your operating costs (or some combination of the two). For example, you might try:
- Increasing prices on select products or services
- Negotiating new contracts to reduce overhead expenses
- Reducing your inventory
- Adopting a new marketing strategy
- Refinancing business loans
Business loans can help you improve your cash flow, but the loan itself won’t actually help your net profitability. If anything, the interest payments can add to your operating costs, so it’s best to reserve loans for financing business improvements that lead to more sales.
A Quick Check-Up
Having better control of your data will make you a better leader and make your company more successful. Net profit margin is a simple, basic KPI that can be used to track the performance and progress of your organization and give you a quick glimpse into its financial health.
Check out the other KPIs in our series below:
