Net profit, also known as net income, shows the actual amount of money a company makes after deducting all expenses, including operating costs, taxes, interest, depreciation and amortisation, from total revenue.
The net profit margin is a financial ratio of net profit to revenue, and is essential for understanding whether you are growing your business sustainably and with room to expand.
"Net profit margin is a measure of how much money you are really making, specifically compared to your sales," says Dan Heelan, Business Services Director at accountancy firm Heelan Associates.
"We see many businesses selling a lot but, when everything is paid for, making next to nothing."
How to calculate net profit margin, with formula
To calculate net profit margin, take your net profit and divide it by your total revenue, or the amount of money generated from sales before any expenses are removed. The resulting figure is then expressed as a percentage, showing how much of every pound earned translates into profit.
Net profit margin can be calculated using the following formula:
Net profit margin = Net Profit / Total Revenue x 100
Net profit margin example
Company A generated £100,000 in total revenue from selling its goods between January and March. It cost £20,000 to make them and the business incurred further operating expenses of £15,000 and taxes and interest payments of £5,000.
To calculate net profit margin, start by calculating gross profit, which is total revenue minus the direct costs incurred from making your goods, known as cost of goods sold (COGS). Then deduct all other expenses from gross profit to arrive at net profit.
Net profit: £100,000 - £20,000 - £15,000 - £5,000 = £60,000
You can then use the net profit margin formula to convert net profit into the margin ratio as follows:
Net profit margin: £60,000 / £100,000 x 100 = 60%
Understanding net profit margin
Robin Waite, founder of coaching company Fearless Business, uses net profit margin to understand if and how much money is available to re-invest for business growth after all his financial obligations have been met.
"I look to re-invest 10% of revenue back into growing the business, so if my net profit margin slips, then growing the business might need to be delayed for a month or two," he says.
A good net profit margin for Waite is anything above 30% which, if met or exceeded, means he can consider investments such as trialling a new service or coaching programme. Below 20%, he says he may need to pause business growth or eat into working capital. "I only change my strategy and test things out when my net profit margin looks really healthy," he adds.
Advantages and disadvantages of net profit margin
Advantage: It measures performance
Net profit margin is an easy way to show how efficient a company is at selling its goods and managing its expenses. "Net profit margin is pretty straightforward in showing how much money is left at the end of all the inputs into a business and it allows you to confidently make investment or cost-saving decisions," says Waite.
Advantage: It's useful for comparisons
Net profit margin is useful for comparing the year-on-year performance of your company and for comparing your business to others in the same sector. This makes it a key metric for potential investors, who use it to compare the financial health of businesses operating in the same industry, says Heelan.
Advantage: It supports investment
A healthy net profit margin shows potential investors that you're successful at selling your goods while controlling your costs. As Heelan says: "It's another metric for them to assess and hopefully gain confidence."
Disadvantage: It can misrepresent your financial position
Taken in isolation, net profit margin doesn't fully represent your financial position, as it doesn't consider factors like sales volumes or cash flow, says Waite. For example, Waite invoices clients in advance and they pay in installments, which when accounting on an accruals basis means net profit margin can look very healthy even though the cash hasn't yet been paid into the business.
Large, one-off investments can also skew net profit margin. A marketing campaign with a large upfront price-tag for example, won't necessarily generate results for several months. The American Express® Business Gold Card has a 54-day payment period meaning you can hold cash in your account for longer, giving you more flexibility in your cash flow¹.
Disadvantage: It can inhibit long-term decision-making
Focussing too much on growing net profit margin in the short-term can cause you to shy away from making longer-term investment decisions. You may miss opportunities to invest in skills training, or perhaps you resort to cutting costs in areas like marketing that may take longer to bear fruit.
Net profit margin vs gross profit margin
Gross profit subtracts COGS from your revenue, and gross profit margin then divides this figure by total revenue to generate a percentage margin.
Net profit goes further, deducting COGS and all other business expenses from revenue, with net profit margin also expressing this figure as a percentage total income.
Looking at gross profit margin and net profit margin side-by-side can be really valuable, says Heelan. Let’s say your sales increase and your COGS stay the same, which means gross profit margin increases. Imagine that alongside this your net profit margin declines. This suggests that beyond COGS, your costs are growing as your sales increase. Perhaps customer service costs and other administrative expenses have risen to support this rise in sales.
You can use this data to make important decisions, such as how much you want to grow, whether you need to increase prices or lower costs. It may be that, for example, there comes a point when it doesn't make sense to sell higher volumes as it's pushing your costs too far above revenue.
Improving net profit margin
Raise prices
This is one of the easiest ways to increase net profit margin and it doesn't usually cost your business anything extra, says Heelan. Just be mindful to keep prices within the range your customers are willing to pay.
Reduce costs
Cutting costs will improve net profit margin. Perhaps you can find cheaper rates for rent, utilities and insurance, or negotiate better deals with your suppliers.
Increase productivity
Increasing productivity helps you get more from less, driving up your net profit margin. This can be achieved in lots of ways, such as using technology to relieve staff of administrative tasks, freeing up their time to spend on revenue-generating activities.
Upsell and cross-sell
It costs time and money to acquire new customers, which means retaining them and increasing your sales volume per client can be much more lucrative than focussing all your attention on new business.
"It costs 17 times more to sell something to a new client as it does to upsell or cross-sell to an existing client," says Waite. Consider how to make more money from relationships you've already invested in.
Net profit margin can teach you much about your business model, concludes Heelan. When used alongside other measures of profit like gross profit margin, it can really help you to make important strategic decisions for business growth.
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