As the founder of a sales advisory service, I am often asked to analyze businesses for all kinds of fundamental metrics — revenue, cost of goods sold, and profitability. While one company might be satisfied with a higher dollar amount of profit than another, if they really want to compare competitors of any size with each other, they need to focus on the rate of profit.

How much do they keep of each dollar they make?

Let’s dive deeper to better understand the concept of net profit margin.

What you’ll learn:

• What is net profit margin?
• Why is knowing net profit margin important?
• How to calculate net profit margin
• Factors that affect net profit margin
• Other profit metrics to know
• Comparing net profit margin to industry averages
• Using technology to understand profitability

What is net profit margin?

Net profit margin is the percentage of profits that you keep after expenses are paid. It’s commonly known as “profit” (shown as a percentage). When a business is described as “profitable,” it has a positive net profit margin. The higher, the better. If a company is taking a loss, it has a negative one. There are other important ways to measure how a company is doing, but the rate of profit, especially over time, is a quick and easy way to assess any venture.

Why is knowing net profit margin important?

Knowing the net profit margin of a business helps with three basic tasks:

• Measuring company health: You can judge whether a business is managing its revenues, expenses, and operational efficiency well based on the rate of profit it’s taking in. Low and negative margins might reveal a poorly run company (and vice versa).
• Comparing companies: Investors and analysts can compare different businesses of different sizes based on their margins, for help with forecasting and possibly determining where to park their capital.
• Analyzing trends: Watch how the margin changes over time. Is the company taking off or going down the drain? This can affect stock price, opportunities for expansion, and more.

Whether you own the business, invest in it, or just need to watch its movements, net profit margin is a fast benchmark to see how it’s doing.

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How to calculate net profit margin

Use these formulas to calculate your net profit margin:

Net income / R x 100

Net income = R – COGS – E – I – T

Defining all variables

Variable	What it represents	What it really means
Net income	Total revenue minus all expenses	Profit left over after all expenses have been subtracted from total (gross) income.
R	Total revenue	All money brought in by selling goods or services, plus other income (such as interest or dividends on investments).
COGS	Cost of Goods Sold	The direct costs of creating the goods (i.e., products) that a company sells. If you’re selling cars, that would be all the parts used to make the cars, plus the labor in assembling them. This wouldn’t include the cost of sending the cars to dealerships, nor salespeoples’ commission or wages.
E	Operating expenses (OpEx)	The costs of running a business, such as rent, marketing, payroll, research and development, insurance, and more.
I	Interest	The interest owed on company debts, mainly for borrowed funds. This is different from operating expenses, which come from the daily running of the business.
T	Taxes payable	All the taxes a business will owe in a given 12-month period on expected income.

All these figures should be available on an income statement. You multiply the final result of the first formula by 100 to make it a percentage.

On most income statements, you can find the net income already calculated. If you’ve ever heard the term “the bottom line,” that refers to net income. After all, it appears on the bottom of these types of statements.

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Factors that affect net profit margin

Business is complicated. Analysts have to take a holistic view to understand why margins move the way they do. Pay attention to these sometimes false indicators that can throw off your analysis of net profit margin, especially in shorter time frames:

• Accounting manipulation: Whether the company changes its accounting policies, or is actively trying to delay or speed up the realization of revenue, you have to watch out for inconsistencies and fraud. These aren’t always clear from just the net profit margin alone.
• Depreciation: The allocation of cost over the life of a big investment (like a fleet vehicle or other piece of equipment) will drive up expenses and drive down net profit. Review the earnings before interest, taxes, depreciation, and amortization (EBITDA) to get a clear picture of profitability when depreciation is in play.
• Debt: Debt from financing creates interest payments that a business has to pay. The more debt, the more interest expense. You can compare companies with earnings before interest and taxes (EBIT) to get a view of their operational profitability when they have very different debt levels or funding strategies.
• Extraordinary events: Natural disasters and market crashes aren’t part of normal business operations. You shouldn’t judge long-term profitability on uncontrollable temporary events.
• One-time gains or losses: If a company sells off a big asset, like one of its five manufacturing plants, they’ll have a huge revenue boost and a decrease in the operating expenses associated with it. But they can’t do that annually, so their margin will be falsely increased this year.
• Tax changes: If tax laws affecting a business are changed by legislators, it can cause a change in profitability that has nothing to do with a company’s actions. For example, an overall decrease in tax rate or a new subsidy for a product would improve their margins, but would normalize over the following years.

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Other profit metrics to know

Profit margin is great for quick bottom-line assessment, but it’s hardly the only way to measure a company. Try these additional metrics to avoid over-relying on just net profit margin, which can be influenced by the factors outlined above.

The difference between net and gross profit margin

Net profit margin measures the final ratio of take-home profits after every expense is subtracted. Gross profit margin is the proportion of profit after just the COGS are subtracted. This helps you see how much profit is generated from producing a company’s goods. All other expenses and overhead are ignored. This might also provide a goal that can be reached through improving operational efficiency.

Understanding operating profit margin

Operating profit margin is also known as EBIT (Earnings Before Interest and Taxes). You take revenue and subtract COGS, depreciation, and amortization. It reveals what percentage of profit is a result of producing the company’s goods and of operating its business, but not of financing.

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Comparing net profit margin to industry averages

Every industry has an average net profit margin for you to benchmark against. Because these are aggregates, they already account for outliers with extraordinary circumstances.

Industries with low on-average profit margins

• Construction: Not only are materials and labor pricey, but the revenue is project-based and takes a long time to realize.
• Grocery stores: These essential goods sellers have high volumes with low margins and very price-sensitive customers.
• Entertainment: Whether games, movies, or outings, labor and investment costs soar while competition runs rampant and customers stay flakey.
• Retail: Brick-and-mortar shops have a lot of competition, little control over pricing, and high operating costs.
• Transportation and logistics: Trucking, freight, and shipping all carry high fuel costs, major capital expenses, and a truckload of regulations.

Industries with high on-average profit margins

• Financial services: There’s a high demand for their services, and all the funds that get poured in are usable for other investments, driving up potential revenue streams.
• Health care: These providers have an essential service with inelastic demand, which is increasing because of the population aging, and increased efficiency due to technological innovations.
• Pharmaceuticals and biotechnology: The high barriers to entry, such as research and development investments and patent protections, keep new competitors out, and their products are often essential.
• Real estate: Investors and developers both benefit from their assets gaining value with time, and collecting rents in the meantime with minimal maintenance costs.
• Technology: Software and services tech firms are easy to scale, have low marginal costs, and generally face strong demand.

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Using technology to understand profitability

Sales software can play a role in forecasting current and future probability by looking back on past tracked performance. A sales tech stack helps track things like the amount of potential revenue in a pipeline and previous years’ sell-through rates, which help you figure out the likelihood of realizing that revenue.

Sales and customer relationship management (CRM) tools also help with sales analysis. You can see things like dips and peaks in sales, track which products do best, average sales cycles for different product lines, and more. All this data can be compared with things like COGS to make decisions that affect the bottom line.

For example, a high-revenue product line might look good on the top line of an income statement.

But if it takes a very long time to sell and adds higher-than-average amounts to operating expenses because of the percentage of the sales team’s salaries tied to it, the product might end up being more trouble than it’s worth. It might need to be scrapped in favor of lower-revenue, but higher-profit product lines, which can be sold in greater volume.

Over time, decisions like this can improve the net profit margin.

You can also use sales software to influence pricing, which can ultimately drive profitability. By reviewing costs in previous years, you might opt for a Cost Plus Pricing strategy. This simply means adding COGS and multiplying it by one plus the profit you want. This way, your business makes a net profit on each unit of a product sold.

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Start your analysis with net profit margin

When you understand your net profit margin, you’ll have a look at your company’s financial performance over time. Your margins can signal an opportunity to expand your business or an area for concern. Because every industry has its own benchmarks, you can also see how you’re doing versus the competition.