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How to Determine a Business’s Health by its Net Profit Margin

Determining a company’s net profit margin is valuable because this calculation gives a business and its financial officers a strong picture of the company’s profitability.

Defining Net Profit Margin         

Net profit margin determines the percentage of revenue that ends up as profit after accounting for expenses. Represented as a percentage, it’s calculated by taking the company’s net profit and dividing it by total 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 is 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

Generally, 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 point 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 resulted in 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, for example business fixtures don’t get purchased often or equipment is reduced, net profit margin can demonstrate a noticeable impact.

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