Net Profit Margin: Formula and Calculation

Remay Villaester (May)

What is Net Profit margin?

You may have heard of the term “the bottom line”. But have you ever wondered what it really refers to? In business, the bottom line is the net profit because that is – quite literally – the last number that you see at the end of the business’s profit and loss statement.

Net Profit Vs. Net Profit Margin

Net Profit is the amount that is left after all expenses that the business has incurred in a specific time period deducted from revenue made during the period. When this final number is expressed as a percentage of the revenue, it is called the ‘Net Profit Margin’. This figure tells you how much profit a business generates for each dollar or pound of revenue earned.

💼 Contents:

Net Profit Margin vs. Gross Profit Margin

Businesses incur various costs in order to operate. Some of these costs are directly related to the production of goods and services while others are simply overhead costs from running the business (e.g. staff, marketing campaigns, office rent) also known as operating cost.

Gross Profit Margin

Costs that are related to the production of goods and services are called Cost of Goods Sold (COGS). COGS represents the primary costs incurred on production or getting the products ready for sale.

When we subtract COGS from revenue, we are left with Gross Profit. We then take this a few steps further to get the Net Profit Margin by deducting the operating cost and tax and debt interest from the Gross Profit. Here's a sample income statement to illustrate the stages of different profit margin from Gross Profit to Net Profit:

sample-income-statement

We then get the Gross Profit Margin by dividing the difference by revenue earned to get the percentage of profit. Here's an example based on the entries we have on the sample income statement above:

Gross Profit Margin Formula: Gross Profit/Revenue x 100

Gross Profit Margin = 125,000/300,000 x 100 = 41.67%

Net Profit Margin

After arriving to the Gross Profit Margin, the Net Profit formula then takes it further to get the Net Profit Magin. The first line items are the Operating Costs. This can include costs such as payroll, rent, utilities, insurance, depreciation, etc. Depreciation accounts for the wear and tear that assets such as buildings and equipment go through.

To get the Net Profit, we need to deduct the following from the Gross Profit and get the Operating Profit:

  • Operating Cost
  • Tax and debit interest

Using the same entries from our sample income statement, let's calculate Net Profit using this formula:

Net Profit Formula: Gross Profit - Operating Profit - Tax and Interest

Net Profit = 125,000 (Gross Profit) - 40,000 (Operating Profit) - 12,000 (Tax) = 28,000

Here, our Net Profit is 28,000 and to get the margin we divide this figure by the revenue using this formula:

Net Profit Margin Formula: Net Profit/Revenue x 100

Net Profit Margin = 28,000/300,000 x 100 = 9.3%

Why is it important to know your Net Profit Margin

The net profit margin is a critical measurement for business owners. As a business owner, your objective is to increase your business' profitability. The net profit margin enables you to see how much of your revenue is being translated into profit.

Once you do a deeper dive into the costs on the income statement, you can then identify potential cost reduction opportunities that can help you boost net profitability – and consequently, the net profit margin.

A good net profit margin can also indicate how well the company is managing it's costs against the revenue they're generating. If a company's operation is well managed in terms of cost, this will reflect on the bottom line which is a good figure to look at for investors or banks for companies looking for funding.

The Importance of Net Profit margin to an investor

If you are an investor or a company looking for funding, it's important to understand the significance of Net Profit. The Net Profit is a key indicator of business performance and profitability. It is not enough to look at just the revenues of the business. A company can have growing sales with costs growing at a faster rate.

This would signal declining net profitability even though revenue growth is positive, which could suggest that a business may not be the best investment as it looks like it’s unable to handle its costs effectively.

Investors can also use the net profit margin to compare companies of varying sizes and industries. Because net profit margin is expressed as a percentage, it offers a standardized view of a company’s efficiency in converting its revenues into profits.

This makes it easier for investors to compare and benchmark the Net Profitability ratios across different sectors. It helps them look at companies across a range of different industries and see which one is able to manage its costs optimally.

🔢 Net Profit Margin sample calculation

Take Company XYZ that generated £1,000,000 of sales last year by selling T-shirts to consumers.

  1. Materials for the shirts cost a total of £400,000
  2. Employee wages and salaries paid totalled £100,000.
  3. Rent (£100,000)
  4. Insurance (£2,000)
  5. Advertising and marketing (£10,000)
  6. Interest (£20,000) and depreciation (£50,000)

What is the net profit margin? Assume a tax rate of 30%.

Using the items above, let’s calculate the Net Profit Margin:

1. Identify your Revenues

In this case, it is £1,000,000

2. Subtract COGS from Revenues to get Gross Profit

£1,000,000 - £400,000 = £600,000

3. Calculate Operating Expenses

Rent (£100,000) + Insurance (£2,000) + Advertising and marketing (£10,000) + Depreciation (£50,000) = £162,000

4. Subtract Operating Expenses from Gross Profit to get Operating Profit

£600,000 - £162,000 = £438,000

5. Subtract Interest from Operating Profit

£438,000 - £20,000 = £418,000

6. We get this Pre-Tax Profit

£418,000

7. Calculate Tax based on Pre-Tax Profit

30% of £418,000 = £125,400

8. Subtract Tax from Pre-Tax Profit to get Net Profit

£418,000 - £125,400 = £292,600

9. Express Net Profit as a percentage of Revenues (Net Profit Margin)

net-profit-margin

💡 Note. Net Profit Margin can be expressed in different formulas depending on what stage in the income statement it's being calculated. For example, the above formula only 'takes profit before tax - tax' as the rest have already been deducted before.

How to increase your Net Profit margin when you operate internationally

Entering the global market presents bigger growth opportunities in locales that are not overly saturated yet. It also helps diversify your audience and learn how each economy reacts to your products or services.

However, expanding means exposing your business to some risks that can impact your bottom line quite significantly.

In this section, we’ll discuss some of the risks that you should be aware of if you’re a business operating globally or looking into expanding your business.

💷 Managing FX exposure and risks

When you sell your products or services in different countries, you’re most likely to present the prices in the local currency. This means handling payments in multiple currencies. It's important to understand how this will affect your bottom line as you could lose some money on currency fluctuations.

💡 It's good to have an FX hedging strategy and tools in place to help mitigate these risks. Tools like Wise multi-currency account could help simplify foreign exchange management. You can hold and convert whenever you need and take advantage of exchanges at the mid-market rate at all times.

💰 Consolidating your finances

When you consolidate your income and sales, you need to take into account the revenue that is coming from other subsidiaries of your business and convert other currencies into one (your main currency). Having an automated accounting service to channel these needs could save you some time on admin tasks when preparing financial statements for your company. It also simplifies your tax reconciliation and reporting.

🏦 Tax implications

Income that is generated from foreign investments is also taxable. This means that having a better visibility of your sales and finances is important when reporting to the tax authorities. It's also worth doing more research on double taxation per country to see whether or not you could file a credit relief if you’ve been taxed twice.

📃 Collecting Invoices

Collecting payments for invoices becomes more difficult if you have customers from overseas. The time difference could affect how fast you can get paid and the communication is slow. In addition to that, invoices for foreign clients are often in different currencies and if this is done manually, it could take up more admin time. Automating this process or using e-invoicing could streamline this process and speed up collection.

🚚 Transport costs and fulfilment solutions

If your business is in dropshipping or e-commerce, spend time looking for the most optimal distribution and logistics partner as this affects your customer satisfaction. Transport costs are also often significant when factored into Cost of Goods Sold.

📦 Optimize inventory levels

Using specialist order management software can help you monitor and optimize inventory levels. This has an added advantage of improving your cash flow by ensuring that cash isn’t trapped in inventory purchases that still haven’t been sold to a customer.

All these factors can have a significant impact on how you manage your operations and could therefore affect your bottom line.

Expert Insight from Esther at EFK CompuBooks: Maximise your Net Profit through better FX management

Managing payments in different currencies can become expensive if you have no strategy in place to hedge your funds against FX fluctuations so here are some expert tips to help you mitigate risks associated with FX exposure.

  • If you have reason to believe that the foreign currency in which you are dealing is about to weaken compared to your home or domestic currency, take measures to encourage your customers to pay as soon as possible.

  • If you have reason to believe that the foreign currency will strengthen over the coming weeks, then getting paid in that currency will be worth more if they don't pay you right away. For that matter, if you have a foreign currency balance in the bank and you have reason to believe that this currency will strengthen soon, hold off on converting that currency into your home currency.

  • Do as little converting of foreign currencies as possible. If you can, obtain and use a credit card that is denominated in a foreign currency that you use relatively often. And pay off that card using a bank account denominated in that same currency. This prevents unnecessary currency conversions, and avoids using the outrageous exchange rates that bank and credit card companies tend to charge.

Image
    She has been named twice to the list of Insightful Accountant’s Top 10 QuickBooks ProAdvisors worldwide, with the titles “Top International ProAdvisor” and “Top Trainer/Writer ProAdvisor.”

Receive international payments on time, without the high fees - choose Wise

Wise-business-account

After going through the risks involved in operating globally, you've probably figured that having a single multi-currency account could come in handy when managing multiple currencies.

Most business bank accounts have this covered but how about the cost and convenience?

If you’re looking for an easy way to reduce your international costs and streamline collection, you might want to know more about Wise for Business.

Wise is designed to help global businesses save money on international transactions and remove the hassle of having multiple bank accounts for handling different currencies making it the world’s most international account.

With Wise you can:

  • All your money in one place - easily manage your overseas payments and move money between currencies as and when you need it
  • You’ll always get the mid-market exchange rate - no hidden fees.
  • Make cost-effective, fast and transparent international transfers - perfect for paying overseas suppliers and contractors
  • Secured and regulated by financial authorities
  • Modern and convenient solution - you can make payment on the app and easily track them
Sources:
  1. HSBC international transfer calculator

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