Profitability ratios indicate the company’s ability to generate revenues over and above the operating expenses of the company during an accounting period. Of all the profitability ratios, Net profit margin is the most closely followed ratio by the shareholders.
Expressed in percentage terms, Net Profit Margin can be calculated as below:
Net Profit Margin = Net Income/ Net Sales
Net income is the excess of revenues over operating expenses, interest expense and taxes. In simpler terms, it is the profit of the business after paying off all business expenses, interest costs and government taxes. Further, any preference dividend declared is also subtracted to calculate net income used for estimating net profit margin.
Net sales is calculated by subtracting all trade discounts and sales returns from total sales.
For example, your business has a net profit (profit after tax) of Rs. 8 lakhs and net sales of Rs. 32 lakhs, the net profit margin would be 25% (Rs. 8 lakhs divided by Rs. 32 lakhs). It indicates that the company has been able to generate an after tax earnings of 25% of sales during the accounting period.
Higher the net profit margin, the better it is. Since net profit margin is expressed as a percentage, it makes it easier for the lenders to make comparisons with your peer companies to have a fair idea of how you have been performing. Further, they maintain a close watch on the trend of the net profit margin to ensure that there is not much of volatility over the periods. In case of businesses with cyclical nature like woollen garments etc., the ratio might vary on quarterly basis due to higher working capital requirements during the peak season.
Any change in the net profit margin is closely monitored and scrutinized by the investors and lenders before making the financing decisions. Investors need to be sure that the company is generating sufficient profits to share these profits through dividends. Similarly, the lenders want to be sure that the business is being run efficiently and would be able to pay back their money without any defaults.
Attempts should be made to reduce expenses and increase ancillary incomes to increase the net profit margin. For example, airline companies levy charges on small activities like seat selection etc., which may not otherwsie cost much, thereby boosting the net profit margins. The ratio forms a basis of comparison between various investment opportunities available in the market.
With better net profit margins, many lenders will be willing to fund you through business loans. Loan Frame helps you choose the right business loan and also negotiates the best interest rate and loan amount for your needs. We make use of technology to help you connect to the right lender for your business loan needs.
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