The profit margin tells you how much profit a company makes for every $1 it generates in revenue or sales. Profit margins vary by industry, but all else being equal, the higher a company's profit margin compared to its competitors, the better.
Calculating Net Profit Margin
To calculate net profit margin, several financial books, sites, and resources tell an investor to take the after-tax net profit divided by sales. While this is standard and generally accepted, some analysts prefer to add minority interest back into the equation, to give an idea of how much money the company made before paying out to minority "owners". Either way is acceptable, although you must be consistent in your calculations. All companies must be compared on the same basis.
Option 1: Net Income After Taxes ÷ Revenue = Net Profit Margin
Option 2: (Net Income + Minority Interest + Tax-Adjusted Interest) ÷ Revenue
In some cases, lower profit margins represent a pricing strategy. Some businesses, especially retailers, may be known for their low-cost, high-volume approach. In other cases, a low net profit margin may represent a price war which is lowering profits, as was the case with the computer industry way back in 2000.
Net Profit Margin Example
In 2009, Donna Manufacturing sold 100,000 widgets for $5 each, with a cost of goods sold of $2 each. It had $150,000 in operating expenses, and paid $52,500 in income taxes. What is the net profit margin?
First, we need to find the revenue or total sales. If Donna's sold 100,000 widgets at $5 each, it generated a total of $500,000 in revenue. The company's cost of goods sold was $2 per widget; 100,000 widgets at $2 each is equal to $200,000 in costs. This leaves a gross profit of $300,000 ($500k revenue - $200k cost of goods sold). Subtracting $150,000 in operating expenses from the $300,000 gross profit leaves us with $150,000 income before taxes. Subtracting the tax bill of $52,500, we are left with a net profit of $97,500.
Plugging this information into our formula, we get:
$97,500 net profit ÷ $500,000 revenue = 0.195 net profit margin
The answer, 0.195 [or 19.5%], is the net profit margin. Keep in mind, when you perform this calculation on an actual income statement, you will already have all of the variables calculated for you. Your only job is to put them into the formula. (Why then did I make you go to all the work? I just wanted to make sure you've retained everything we've talked about thus far!)
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This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.
