How to Calculate Net Profit Margin (With Examples)

By Indeed Editorial Team

Updated August 15, 2022

Published October 18, 2021

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Net profit margin, sometimes just net margin, is an essential financial ratio to evaluate the profitability of an organization. Understanding the importance and calculation of profit margin can help you better assess the financial health of a company. In this article, we discuss the definition and formula for calculating net profit margin, discover various other types of profit margins, highlight how to make the required calculations, and identify the benefits and limitations to the margin of net profit.

What is net profit margin?

Net profit margin is one of several critical performance markers of an organization's financial health. A business considers this necessary calculation an essential profitability ratio that explains what percentage of sales remains as profits. When determining the margin of net profit in a company, you typically show the result as a percentage, although a decimal form is also acceptable. The formula measures an organization's net profit for every dollar of revenue earned. The procedure for calculating net profit margin is:

Net profit margin ratio = (net profit / revenue) x 100

Related: A Guide to Finance Skills: Definition and Examples

What is net profit?

Based on the formula, to calculate the profit margin, you must also determine the net profit. Net profit, also called net income or net earnings, is a critical marker of an organization's financial health. Business owners sometimes refer to it as the bottom line, as you can find the net profit on a company's income statement as the last line of information. A company's net profit is the amount of money left after subtracting expenses from the business's total revenue. Expenses include operating costs, the interest owing on loans, taxes, and depreciation costs.

Investors, creditors, and company stakeholders use net profit or net income to evaluate the organization's overall profitability. Because it shows the amount of money retained after the company pays for all expenses, it is an indicator of the efficiency of the organization's management. For example, a low or negative net profit can highlight issues such as increased expenses, fewer sales, ineffective pricing strategies, or poor marketing performance. A company's management can then examine these areas further for more significant analysis.

Related: How to Calculate Net Income for an Individual and a Business Organization

Other types of profit margin

When analyzing a company's financial health, there are four levels of profit margins to consider. You can see the four profit margins on an organization's income statement in the following order:

Gross profit margin

Gross profit margin is the amount of money left over from sales revenue after the company pays the direct costs of the products or services. This calculation considers the cost of goods sold (COGS). Items included in the cost of goods sold are raw material costs and the labour to produce the product. Management calculates this margin per product, and companies with multiple products benefit from analyzing their gross profit margin. The formula for gross profit margin is:

Gross profit margin = (net sales - cost of goods sold) / net sales

Related: How To Calculate Variable Cost With Examples

Operating profit margin

The company then uses the money available from the gross profit margin to pay for indirect costs. Indirect costs are expenses not directly related to the cost of the goods sold or produced. For example, these expenses include salaries for employees in other company departments, such as accounting, marketing, research and development, and administration. Additional costs include rent, office supplies, advertising materials, and utilities. The amount of money left over is the company's operating profit margin. The formula for operating profit margin is:

Operating profit margin = (operating income / revenue) x 100

Pretax profit margin

Once a company knows its operating income, it pays interest on any debts and adds any revenue produced through interest gained. Next, an accountant makes adjustments for non-recurring items, such as gains or losses from a discounted operation. The amount left is pretax profit, also known as earnings before taxes. You would then divide the earnings before taxes amount by the revenue to determine the pretax profit margin. The formula is:

Pretax profit margin = operating income - interest expenses + adjustments) / revenue

How to calculate net profit margin

Follow these steps to calculate your margin for net profit:

1. Determine the net profit

The first step is to calculate the company's net profit. To begin, you can locate the total revenue for the business on the income statement. Next, you subtract the cost of goods sold, operating expenses, interest paid, and taxes. The result of this calculation provides you with the net profit. Below is the formula:

Net profit = revenue - cost of goods sold - operating expenses - interest - taxes

2. Divide the net profit by the revenue

Once you have the net profit from step one, you can divide that number by the revenue. For example, based on the income statement, the company has made $250,000 in revenue. You have determined the net profit from step one as $100,000. The formula would look like this:

Net margin = net profit / revenue or $100,000 / $250,000

Net margin = 0.40

3. Multiple the resulting number by 100

To turn the number into the net profit ratio percentage, you multiple the result by 100. Using the example above:

Net margin = 0.40 x 100 = 40%

In this scenario, the company's net profit ratio is 40%.

Related: What Is Net Income After Tax? (With Definition and Examples)

When to use the margin of net profit

Because the margin of net profits considers all expenses, not only the cost of producing the items, there are several analytical situations when this calculation is beneficial. These scenarios include:

  • forecasting profits based on the company's revenue

  • assessing whether the company's current practices work

  • comparing the profitability of various companies in the same industry

  • analyzing whether the company is generating enough sales profits

  • determining whether overhead and operating costs of a business are reasonable

Related: Financial Analyst Interview Questions (With Sample Answers)

Limitations of using the margin of net profit

There are several limitations to using the net profit ratio percentage when evaluating an organization's performance, as with any financial calculation. Several examples of scenarios when this number may not be an accurate representation include:

Comparison of companies in different industries

Profit margins between various industries can be vastly different. Operating expenses and the cost of goods sold can vary significantly depending on the type of product manufactured. For example, the cost of goods sold for an artisan bakery has very different expenses than a manufacturing plant that produces large-scale steel valves for the petroleum sector. Using profit margin ratios to compare companies is best done when looking at businesses within the same industry or similar business models.

Companies with debt

Companies that hold a more considerable amount of debt may have a smaller profit margin. This is because of higher interest expenses paid on the short- or long-term loan. Not all debt is negative and is essential for business expansion and growth. When companies take on business financing with strategy and intention, it can produce significantly positive long-term results. The short-term effect is a decreased profit margin ratio.

Depreciation expenses

When an organization has a significant amount of fixed assets, such as property, buildings, land, or equipment, the profit margin can be lower than other businesses. Because of higher depreciation expenses on a large amount of newer fixed assets, the result is an automatically decreased margin of profit. This is the case even if the business has a healthy cash flow.

Profit manipulation

The manipulation of certain expenses can partially control a company's profit, allowing management to affect the profit margin numbers. For example, management can temporarily reduce long-term expenses, creating a more significant profit margin. This can cause many issues for investors and stakeholders, so it's best to review all financial information instead of only one value.

Example of net profit ratio

To better understand the process of calculating the net profit ratio for a company, below is an example of the financial information used:

Dan the Bee Man Apiaries

Dan the Bee Man Apiaries finished its fiscal year on September 30, 2021, and he wants to determine its net profit ratio. Dan knows that the total revenue for the year equalled $185,000. After completing his income statement, he can calculate the margin for net profit. He uses the following formula:

($62,000 net profit / $185,000 total revenue) x 100 = 33.5% net margin

Income statements provide a helpful reference when determining profit margins and other calculations. For example, the table below shows the various critical numbers for Dan the Bee Man Apiaries, including the net profit ratio at the bottom of the statement:

Dan the Bee Man Apiaries
Income Statement for Fiscal Year Ending December 30, 2021

Total revenue: $185,000
Cost of goods sold: ($58,000)
Gross profit: $127,000

Operating expenses
Salaries: $20,000
Rent: $10,000
Utilities: $5,000
Depreciation: $5,000
Total operating expenses: ($40,000)

Interest expenses: ($10,000)
Taxes: ($15,000)
Net profit: $62,000

Net profit margin: $33.5%

Please note that none of the companies mentioned in this article are affiliated with Indeed.

Explore more articles