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:
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:
- Gross sales: $4,850,000
- Sales returns: $50,000
- Net profit before tax: $960,000
- Corporation tax rate: 50%
Required: Calculate the company’s net profit ratio.
NP ratio = ($480,000*/$4,800,000**) × 100
*Net profit after tax = 960,000 × 0.5
**Net sales = $4,850,000 – $50,000
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.