Net Profit Ratio: Definition

The net profit ratio (also known as net profit margin) is the net profit after tax as a percentage of net sales.

Net Profit Ratio: Formula

The formula to calculate the net profit (NP) ratio is:

net-profit-ratio-formula

Both the components in this formula—net profit and net sales—are usually found in the trading and profit and loss account or income statement.

The net profit ratio, taken together with the return on equity (ROE) ratio, shows how well the company marks up its goods for sale and how well it manages to contain its indirect expenses within the gross profit margin.

As explained in the gross profit ratio, certain companies with heavier overheads need to have a higher gross profit margin.

If we take gross profit as a percentage of sales (gross profit ratio) and then relate it to net profit as a percentage of sales (net profit ratio), we can evaluate the efficacy of a company’s pricing policy.

If a high gross profit margin does not translate into an adequate net profit percentage, one of the reasons why could be that higher prices are affecting the sales volume. As a result, the overall profit is dropping.

The other reason could be that the indirect expenses (i.e., overheads) are too high in relation to the volume of business handled.

Net Profit Ratio: Example

The following information was extracted from the accounting records of John Trading Concern:

Required: Calculate the company’s net profit ratio.

Solution

NP ratio = ($480,000*/$4,800,000**) × 100
= 10%
*Net profit after tax = 960,000 × 0.5
= $480,000
**Net sales = $4,850,000 – $50,000
= $4,800,000

Interpretation

John Trading Concern’s net profit ratio is 10%. For a trading company, that’s generally a good return on sales.

However, a true evaluation of management’s efficiency in generating a return on sales is possible only when this ratio is compared along with others relevant to the industry, or with the industry’s average net profit ratio.

Net Profit Ratio Calculator

Frequently Asked Questions

What is the difference between net profit ratio and net sales?

Net profit is calculated as revenues less all expenses, which include cost of sales, salaries, interest on loans taken for business operations, rent paid for premises used in business operations etc. Net sales, on the other hand, is simply sales less any returns and discounts.

What is the difference between gross profit margin and net profit margin?

Gross profit (GP) represents the difference between selling price per unit and cost of goods sold per unit. At the same time, the net profit margin is how much money the company generates for every dollar in sales. Net profit is calculated by deducting all expenses from total revenue.

What are examples of companies with high gross profit margins?

Companies that have higher degrees of specialisation can afford to have a lower gross profit margin because they are able to produce more products at a lower cost. Software companies, for instance, often have high gross margins because they can create a single product and then sell it to a larger market.

Why do companies report a gross profit instead of a net profit?

Companies prefer to report gross profits because it gives a better indication of the company's overall profitability. It is more useful to know how efficient a business is in generating revenues from their own products and services, compared with looking at earnings after all expenses have been deducted.

What do the terms ‘gross margin’ and ‘net margin’ mean?

They are related, but opposite ideas. Gross margin represents the ratio of gross profits over total revenues for a company; net margin denotes the ratio of net profits over total revenues.

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