How to Determine a Business' Health by its Net Profit Margin

When it comes to figuring out a company's net profit margin, this calculation gives a business and its financial officers a much better picture of the company’s profitability.

Defining Net Profit Margin

Net profit margin determines the percentage of revenue that ends up as profit after expenses are accounted for. Represented as a percentage, it's calculated by taking the company's net profit and dividing it by the entire revenue.

Looking at the Formula Itself

When it comes to calculating the net profit, it goes beyond the gross margin calculation, which only factors in the "cost of goods sold" – or how much the input materials and direct labor cost the company to produce saleable goods. Determining net profit includes factoring in the cost of goods sold figure, but also includes other expenses, such as payroll, lease payments, taxes, and others.

Once all cash flow, expenses and costs are factored in, whatever amount remains would be considered the net profit. The total revenue is self-explanatory as it's simply 100 percent of a business' sales in a defined time-frame. From there, the net profit is divided by the company's total revenue, and then multiplied by 100 to get the percentage or net profit margin.      

Potential Explanations for Varied Net Profit Margins

Ideally, the higher the net profit margin is, the better the financial health of a company. However, a low profit margin for a period of time or over the long term doesn't necessarily mean a business is poorly managed. There are many reasons why a low net profit margin may exist and persist.

Different Margins Depending on Each Industry

As Forbes and Sageworks points out, the higher the net profit margin is, the better it is for the company. However, there are some considerations when it comes to what’s expected for different industries. For example, looking at the data ending June 30, 2017, for the previous 12 months, the Medical and Diagnostic Laboratories industry saw an average net profit margin of 12.1 percent. Conversely, “Accounting, Tax Preparation, Bookkeeping, and Payroll Services” saw a net profit margin of 18.4 percent.

While these industries are on the high end, Forbes and Sageworks point out that other industries, such as the grocery industry, are still profitable, but do so by making their profits on lower margins, with a much higher volume. 

Financing Considerations

Another factor that can lower a company's profit margin is how its financing is structured. If a company chooses to incur debt financing to buy fixtures or pay employees to run operations, interest expenses,  – especially initially – , could negatively impact a company’s net profit margin.  

Infrequent or One-Time Exceptions to Operations

If a business has recently sold a profitable (or unprofitable division) and that sale has made a material change in revenue, especially for a single quarter, it can provide an anomaly in a company's net profit margin calculation. Similarly, if business fixtures don't get purchase often or equipment is reduced, for example, net profit margin can be impacted noticeably.

Regardless of the industry, understanding business’ net profit margin is, another helpful tool in determining how and why a business is making or losing money.

Sources:

https://www.sba.gov/offices/district/nd/fargo/resources/earning-more-profit-not-all-sales-are-equal

https://www.sba.gov/blogs/understanding-gross-margin

https://www.forbes.com/sites/sageworks/2017/08/06/these-are-the-10-most-profitable-industries/#7660b4d115f0 

https://blogs-images.forbes.com/sageworks/files/2017/08/most-profitable-2017.png

These articles are intended to provide general resources for the tax and accounting needs of small businesses and individuals. Service2Client LLC is the author, but is not engaged in rendering specific legal, accounting, financial or professional advice. Service2Client LLC makes no representation that the recommendations of Service2Client LLC will achieve any result. The NSAD has not reviewed any of the Service2Client LLC content. Readers are encouraged to contact their CPA regarding the topics in these articles.

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