In the previous lesson, we have explored operating margin. To have a complete grasp of the three major profitability ratios, today we are going to tackle the concept of net margin using the example of Procter & Gamble.
Net profit margin (or net margin) is a crucial profitability indicator measuring the percentage of revenue made by a company as a result of its total net sales during the reporting period.
In essence, net margin shows what percentage of sales has turned into profits over a given time period.
When performing an analysis, you have to carefully evaluate the net profit margin along with the gross profit margin and operating profit margin.
Net Profit Margin Formula = Net Profit/Net Sales х 100
It is essential that all three indicators come up to the mark. Only then can we be sure of the company’s normal profit margin.
Net Profit Margin Formula
Net profit margin is equal to net profit divided by total revenue typically expressed as a percentage. E.g., a 15% profit margin means that the company has $0.15 in net income for every $1 of revenue.
The formula includes two figures:
1. Net profit (net earnings, net income) is the amount of profit that remains after the production costs have been subtracted from revenue. In other words, this is sales revenue minus COGS (cost of goods sold), SG&A (selling, general & administrative expenses), depreciation and amortization, interest, taxes, as well as other expenses. You can find the relevant figures by checking out the profit and loss statement.
2. Net sales (revenue). The profit and loss statement starts off with gross sales i.e., the overall income made by the company. However, we need to subtract the amount of sales returns and allowances from gross revenue in order to find out the net profit.
You’ve got the following figures:
- Gross sales are 350 000
- Sales return is 5,000
- Net profit is 20,000
1. Let’s find out the net sales:
Net Sales = (Gross Sales – Sales Return) = (350,000 − 5,000) = 345,000
2. Using the formula, this is how we calculate the operating margin:
Net Margin = Net Profit / Net Sales * 100 (Net Profit / Net Sales * 100) = 20,000 / 345,000 * 100 = 5.80 %
Real-world case. P&G
1. Procter & Gamble net margin for the accounting year ended in June 2020:
Net Profit Margin = Net Profit / Net Sales * 100 = $13,027 / $70,950 * 100 = 18.36 %
2. Procter & Gamble net margin for the quarter ended in September 2020:
Net Profit Margin = Net Profit / Net Sales * 100 = $4,277 / $19,318 * 100 = 22.14 %
In other words, Procter & Gamble generates $0.22 in net profit for every $1 of revenue.
3. Net margin Procter & Gamble is growing which is a good sign. As far as net margins go, P&G greatly surpasses 90% of consumer goods companies. The industry average is 2.93.
4. In real-time mode, Procter & Gamble’s net margin has been gradually increasing since mid-2019. Net margin has tripled since March 2020. The highest level of P&G’s net margin was in 2017 and totaled 23%.
- The investors can evaluate and make forecasts regarding business performance by keeping a close watch on the dynamics of net margin.
- The net margin expressed in percentage and not in monetary terms allows making an easier comparison of peer profitability across the industry, regardless of the companies’ size.
- Typically, the higher it is, the better. However, you need to perform an unbiased evaluation to be on the safe side. Net margin will vary drastically from sector to sector and depending on the company size.
- Businesses with high net margins within a single industry are considered more efficient. Such companies will remain more stable during the industry decline.
- In an ideal scenario, the net profit margin should remain at a certain level or increase over a long period of time. That’s what the investors need.
- Although net income and earnings per share (EPS) are the most recognized metrics for measuring profitability and business evaluation, they are less reliable than others. This is due to the fact that reported profit can be easily manipulated by adjusting the figures of depreciation, amortization, and non-recurrent items.
- The statement that says that net profit grows in proportion to revenue is quite inaccurate. E.g. There may be long-term costs leading to a drop in net profit. Accordingly, the net profit margin will shrink. So, in order to get a full picture, it is vital to discuss all figures available.
Let’s Sum Things Up
1. The long-term trend of net margin is a great indicator that the company is doing well.
2. Publicly traded companies disclose their net profit margin during the release of reports. Businesses with growth prospects are typically encouraged by the stock price increase.
3. In cases where the net profit figures are less than net sales, you need to assess the situation and look into other information about the company.
4. If the net profit seems unreasonably high, it’s important to figure out the reason behind it. The net margin can be either consistent or grow.
5. Steady drop likely indicates that the company is struggling. By controlling the margin level, the investors can assess prospects beforehand and thus avoid losses in the future.
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