What is Net Profit Ratio? Formula, Calculation, Example

Investors, accountants, and financial professionals often use the net profit ratio to find out about a company's financial health. It shows how companies use their assets to earn profits and generate value for their owners. This ratio can help businesses find new ways to improve their finances and maximise their efficiency. 
Keep reading to find out what the net profit ratio is, its importance, how to calculate it and how it is different from the gross profit ratio.

What is the Net Profit Ratio?

Net profit ratio, also known as net profit margin, measures a company's financial performance or profitability after taxes. It helps measure the company's profit to the total amount of money invested in the business. The net profit ratio reveals the remaining profit after deducting production costs, financing and administration from sales and income taxes.

You can use the net profit ratio to determine the financial value of a company and its overall performance. If we need to explain it in simple terms, net profit margin is a ratio of net profit to the net revenue of a business. It is a good measure for comparing the results of a business with its competitors.

What Does Net Profit Ratio Indicate?

The net profit ratio is essential to a company's financial health. It helps measure a company's capability to keep its expenses under control. This helps in finding out how efficiently a company is spending their money. By tracking the net profit margin, a company can evaluate whether the current practices are working properly or not. 

As companies mention the net profit ratio as a percentage rather than an amount, it is possible to compare the profitability of two businesses even if their sizes are different. With the help of the net profit ratio, investors can evaluate whether a company's management is generating enough profit from the sales. 

The net profit ratio, however, is not an indicator of cash flow as it includes many non-cash expenses like amortisation, depreciation and accrued expenses. 

What is a Good Net Profit Ratio?

A good net profit ratio varies from industry to industry. It also depends on the company's past performance. For example, anything between 0.5% and 3.5% in the retail sector can be considered a good net profit ratio. For other industries, however, these numbers might be extremely low. However, the reason why this percentage is common among food-related companies and retailers is because of high overheads.

In general, however, a net profit ratio of 10% to 20% is considered average. It is, therefore, best to compare a company's net profit ratio with its previous year's net profit ratio to evaluate it and improve it if required. 

A good net profit ratio means that a company is selling its products at a higher price than its manufacturing and distribution costs. This is generally a result of low operation costs, efficient management and strong pricing strategies. 

However, a low net profitability ratio might be due to high operational costs, inefficient management, recession, technological disruption and poor pricing strategy.

Importance of Net Profit Ratio

The net profit ratio is possibly the most important evaluator of a company's overall profitability. It is a ratio expressed in percentage that helps measure net profit to revenue for a business segment or a company. 

This margin shows how much profit each sale generates after considering the business expenses involved in earning revenues. A large net profit margin means more of every rupee in sales is kept as profit.

A good net profit ratio means that a company can effectively control its costs and provide goods or services at a higher price than its costs. The net profit ratio of a company also indicates its efficiency for cost-containment measures over a period of time.

Significance of Net Profit Ratio

The net profit ratio is a crucial financial metric that provides us with a report of a company's financial health by considering its expenses and revenue. 

• This ratio helps evaluate whether a company has an effective pricing strategy and manages its expenses well.
• It helps companies to compare the profitability of a company for different accounting periods. This gives an in-depth understanding of whether their financial measures are doing well or not. 
• It is useful to project a company's net income based on its revenue by tracking net profit ratio over time. 
• This ratio is extremely significant when a company applies for a loan. Financial institutions assess their net profit ratio before deciding whether to grant them a loan or not. 

Banks prefer a company with a high net profit ratio as it proves that they likely have a strong cash flow and, therefore, a better probability of paying back their loan. 

Net Profit Ratio Formula

The formula to calculate the net profit ratio is as follows:

Net Profit Ratio = (Net Profit / Net Sales) x 100

In this formula,

Net Profit = Operating Profit – (Direct Cost + Indirect Expenses),

Net Sales = Sales – Returns

This formula can be modified for use by a non-profit organisation by replacing net profit in the formula with net assets.

Net Profit Ratio Example

Let us assume that ABC company has sales of Rs. 10,00,000 and sales returns of Rs. 5,00,000. Its direct costs are of Rs. 1,00,000 and indirect costs are of Rs. 2,00,000. Then, what is the company's net profit ratio?

The formula is Net Profit Ratio = (Net Profit / Net Sales) x 100

However, to find this out, we need to find out the net sales of the company,

The formula for this is,

Net Sales = Sales - Returns

                  = 10,00,000 – 5,00,000

                  = Rs. 5,00,000

Next is finding out Net Profit, the formula for which is,

Net Profit = Operating Profit – (Direct Cost + Indirect Cost)

                   = 5,00,000 – (1,00,000 + 2,00,000)

                   = 5,00,000 – 3,00,000

                   = 2,00,000

Now Net Profit Ratio = (Net Profit / Net Sales) x 100

                                      = (2,00,000 / 5,00,000) x 100

                                      = 0.4 x 100

                                      = 40%

This means that the company has a net profit ratio of 40%.

Net Profit Ratio Calculator

In the formula, net profit is calculated by subtracting the total expenses from total revenues. The profit in the profit and loss account is calculated by deducting direct costs and indirect expenses from operating profit. 

Net profit percentage is calculated by dividing after-tax profit by net sales. It is the residual profit after recognition of income tax as well as the deduction of manufacturing, financing and administrative costs from sales.

Net profit is the money the company makes after subtracting operational, interest and tax costs for a particular period of time. On the other hand, net sales can be arrived at by subtracting the sales returns, discounts and allowances from total sales. 

How to Improve Net Profit Margin Ratio?

It is generally quite difficult to improve a company's net profit ratio. This is because they tend to pursue high-profit opportunities first, leaving the lower-margin sales for later. However, a good way to avoid such a trap is by pursuing economies of scale, which makes each additional sale less expensive.

• One of the steps you can take to accomplish it is purchasing in bulk, which lowers the cost of material per unit. 
• Another method is to invest in product redesign and automation to reduce the cost of labourers for product assembling.
• Apart from that, businesses can increase sales, reduce sales or do both to get a competitive advantage. This, however, might involve spending more money. If you cut too many costs, it might result in undesirable outcomes like losses in quality, losing skilled workers or shifting to inferior materials. 

The best option for many businesses if they wish to reduce the cost of production without sacrificing quality is expansion. 

Difference Between Gross Profit Ratio and Net Profit Ratio

Following is a tabular representation of the basic differences between the gross profit ratio and net profit ratio:

Conclusion

Several profitability metrics are available for investors to make better decisions. Net profit ratio is one of the most popular metrics among them. Anyone can assess a company's performance by going through the public income statement. However, it is best to consider not just a single metric to decide the company's standing. A holistic approach is good to remain ahead in this competitive market.

Frequently Asked Questions

What is a good net profit margin ratio?

Good net profit ratio is a relative term as it might vary from industry to industry. However, companies generally aim for a profit ratio between 10% to 20%. Here, 10% is considered average, and 20% is considered above average.

How is the net profit ratio calculated?

You can calculate the net profit ratio by dividing net profit by net sales and multiplying it by 100. Following is the formula for better understanding:

Net Profit Ratio = (Net Profit / Net Sales) x 100

How to improve the net profit margin ratio?

Companies can increase sales, reduce expenses or do both to improve their net profit ratio. They can also engage in bulk purchases and invest in product redesign and automation to reduce their costs and increase the net profit ratio.

Is a higher net profit margin better?

Yes, a higher net profit ratio is always desirable as it means that a company generates more profits from each of its sales. This also increases the trust of the investors and lenders towards the company.

Is a 5% net profit ratio good?

The net profit ratio varies from industry to industry. However, as a general rule of thumb, a 10% margin is considered average, and 20% is considered high. Therefore, a 5% margin is low.

Is 7% a good net profit ratio?

According to the rule of thumb, 5% is considered a low margin, 10% is healthy and 20% is high. Therefore, 7% is a bad net profit ratio.

Is an 8% net profit margin good?

Good net profit margin is a relative term as it depends on which industry you are in and your past year's performance. However, a 10% margin is considered average, 20% is high, and a 5% margin is low. Therefore, 8% is a low net profit margin.

Is a 12% net profit margin good?

A good net profit margin varies considerably from industry to industry. However, as per the general rule of thumb, a 10% margin is considered average, and 20% is considered high. Therefore, a 12% margin can be considered as average.