Net Profit Ratio or Net Profit Margin or Operating Profit Ratio – Definition and Explanation:
The net profit ratio (net profit margin or operating profit) represents a business’ net profit as a percentage of its sales revenue. The ratio shows that how much of the sales revenue earned actually comprises of net profit. A 15% net profit ratio reveals that business has earned a net profit of $0.15 for every dollar sales revenue.
To obtain the net profit percentage, the net profit is divided by the value of sales and both these items are taken from the income statement of the business.
The later formula helps analysts to compare businesses with different levels of borrowings.
Click on Analysis of Financial Statement of a Business to read the solved example of net profit ratio.
Use of Net Profit Ratio:
The comparison of net profit ratio with gross profit ratio represents the operating overheads as a percentage of sales. For instance, the increase in net profit ratio with constant gross profit margin might indicate that the business has been successful in controlling operating expenses.
Net profit ratio not only reveals pricing policies of a business but also its ability to control its direct costs and operating expenses. The different competitive strategies and product mix may result in different levels of profit margin among different businesses.
Note: The profit of business often do not portray the complete picture. Increase in profit is no doubt preferable but an increase in profit does not necessarily mean that the profit margin of the business is improving. More specifically increase in costs at higher rate in comparison to sales revenue will reduce profit margin regardless of increase in the amount of net profit. For example, a business which earns a net profit of $24,000 from the sales revenue of $200,000 will have a net profit ratio of 12% ($24,000/200,000). If in the next year profit rises to $30,000 on sales of 300,000, its profit margin would decrease to 10%. We can see that the profit margin has reduced despite of increase in the amount of net profit. This raises the need to control the costs in better and effective manner.