CFOs and controllers leverage a broad array of key performance indicators (KPIs) to effectively monitor the financial health of their organizations and protect their business continuity. A few common examples include EBITDA, operating cash flow, days sales outstanding (DSO), and revenue growth rate.
Of these various metrics used to gauge an organization’s health and performance, however, one of the most important is the net profit margin. Below, we will explore this essential KPI, including what it is, why it is important, and its limitations.
What Is Net Profit Margin?
A net profit margin — or simply “net margin,” in some cases — refers to the amount of net income that is generated by a business. Net profit margins are often expressed as a percentage or ratio of net profits to total revenue.
Net profit margins help executives and investors determine whether their companies are generating enough profit from sales or if overhead and operating costs have gotten too high. They look beyond gross revenue to determine how much usable income an organization is actually generating after expenses.
Understanding Net Profit Margins
Net profit margins serve as foundational KPIs that every organization must carefully monitor. By tracking their fluctuations, a company can determine whether its current strategy is supporting its long-term growth while also forecasting future profits based on past performances.
In addition, since net profit margins are expressed as decimals or percentages, as opposed to dollar amounts, it is, therefore, possible to compare the profitability of two organizations, regardless of their size.
To calculate net profit margin, CFOs or controllers must have access to a variety of financial data, such as:
- Total revenue
- Additional income streams
- One-time payments (i.e., taxes and lawsuits)
- Interest expenses
- Debt obligations
- Investment income
- Costs of goods sold (COGS) and other operating costs
By analyzing each of these factors, executives can calculate their net profit margin and determine whether their company is in the green.
When analyzing an organization’s net profit margins, investors want to see consistently expanding margins as opposed to shrinking or stagnant ratios. For instance, a business may have growing revenue, but if it is incurring additional operating and overhead costs at an accelerated rate, its net profits will shrink.
How to Calculate Net Profit Margins
To calculate your net profit margin, you must first determine your net income by subtracting your operating expenses, COGS, taxes payable, and interest (on debt) from your gross revenue. Divide the result by your total revenue and multiply the figure by 100 to convert it to a percentage.
Alternatively, you can locate your net income on your organization’s income statement, divide that figure by your revenue, and multiply the result by 100.
Net Profit Margins vs. Gross Profit Margins
Gross profit margins are another commonly used financial KPI.
A business’s gross profit is calculated by subtracting its COGS from its gross revenue. Keep in mind, however, that COGS measure the raw material costs and expenses directly associated with creating products; they do not include costs such as rent, freight, payroll, or utilities.
After calculating your gross profit, you must divide that figure by your total revenue and then multiply it by 100 to determine your gross profit margin. Gross margins are useful for determining how much profit your organization is generating from producing its goods, as they exclude various overhead costs, interest on debt, and taxes.
If you have healthy gross profit margins, your material costs and production process expenses are likely sustainable. However, if you have a good gross profit margin but a low net profit margin, it is likely that interest on debt, taxes, and operating expenses are to blame.
Limitations of Net Profit Margins
Net profit margins are important metrics for assessing the financial health of your organization, but they can be misleading if a major one-off item is included in the calculation.
For instance, if an organization sold an asset during a particular assessment period, its net profit margin would be unusually high. Conversely, if the company settled a lawsuit and had to pay a large settlement, its net profit margin would be lower than normal.
Additionally, net profit margins do not provide insights into revenue or sales growth. To learn more about these important financial health factors, CFOs will need to turn to other metrics, such as revenue growth rate. Nevertheless, net profit margins tell an important part of the story and should thus be on every CFO’s radar.
Integrating Net Profit Margin Into Your Financial Performance Assessment
Net profit margins are valuable metrics that fill in an important piece of the financial puzzle. However, to adequately measure the financial performance and health of your organization, you should also pay close attention to metrics such as:
Cumulatively, these will provide a holistic view of your organization so that you can proactively mitigate risks, guide the C-suite’s decision-making processes, and progress toward your organizational goals.