The net profit ratio is the net income of the business expressed as a percentage of the revenue, and is a measure of the overall profitability of a business. It is calculated by dividing net income by revenue. Alternatively the ratio is also referred to as the net margin or net profit Margin.
Formula for Net Profit Ratio
The net profit ratio formula is used to calculate the ratio as shown below.
- Revenue is found at the top of the in the income statement of the business. It may also be referred to as sales or turnover.
- Net income is found at the bottom of the income statement and for that reason is sometimes referred to as the bottom line.
How do you calculate Net Profit Margin?
| Revenue | 44,000 |
| Cost of sales | 17,600 |
| Gross margin | 26,400 |
| Operating expenses | 13,500 |
| EBITDA | 12,900 |
| Depreciation | 6,500 |
| Operating income | 6,400 |
| Finance costs | 2,000 |
| Income before tax | 4,400 |
| Income tax expense | 900 |
| Net income | 3,500 |
To demonstrate, in the example above the net income is 3,500 and the revenue is 44,000. Accordingly the net profit ratio is given by using the formula as follows:
Net profit ratio = Net income / Revenue Net profit ratio = 3,500 / 44,000 = 7.95%.
It is important to note that the ratio has been expressed as a percentage by multiplying the answer by 100.
What does the Net Profit Ratio show?
The net profit margin ratio shows what percentage of the revenue is left after deducting all costs. The higher the ratio the more profit the business earns on its revenue.
Useful tips for using the Ratio
- The ratio will vary from industry to industry, so it is important to make comparisons to similar businesses in your sector. If your net profit ratio is substantially different from other businesses within your sector it will need investigation to ascertain why. The fact that the ratio is expressed as a percentage makes it possible to compare the profitability of different businesses regardless of size.
- One off items should be excluded from both revenue and net income, as the ratio is a measure of the operating performance of the business.
- The ratio can be improved by improving net income either by reducing costs or by increasing revenue.
- The net profit margin is an important measure of a business’s overall profitability. Consequently the aim is to get the ratio as high as possible.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.