Net profit margin (also known as “return on sales”) is a profitability ratio that measures the percentage of net income to sales.
Comparing net income of two different periods or two different companies using the dollar values can sometimes be inappropriate because of size differences.
The use of net profit margin negates the effect of size for better analysis of an entity’s performance.
Net profit margin makes use of information presented on the income statement.
Net profit margin (return on sales) is computed using this formula:
Net Income ÷ Net Sales
It is important to note that "net sales" is used in the computation. Net sales is equal to gross sales minus any sales discounts, returns, and allowances. The use of net sales instead of gross sales makes the computation more accurate as the "true" sales revenue is reflected.
| in millions of $ | Year 2 | Year 1 | |
| Gross sales | 1,500 | 960 | |
| Less: Sales discounts | 12 | 9 | |
| Sales returns and allowances | 20 | 15 | |
| Net sales | 1,468 | 936 | |
| Less: Cost of sales | 1,158 | 671 | |
| Gross profit | 310 | 265 | |
| Less: Operating expenses | 143 | 55 | |
| Operating income | 167 | 160 | |
| Less: Interest expense | 9 | 10 | |
| Earnings before tax | 158 | 150 | |
| Less: Taxes | 55 | 52 | |
| Net income | 103 | 98 |
Net profit margin (Y1) = 98 / 936 = 10.5%
Net profit margin (Y2) = 103 / 1,468 = 7.0%
The net profit margin declined in Year 2. Notice that in terms of dollar amount, net income is higher in Year 2. Nonetheless, it represents only 7.0% of sales; while in Year 1, it represents 10.5%. For every dollar of sales, the entity made $0.07 in Year 2 and $0.105 in Year 1. Hence in terms of managing costs and expenses, the company did better in Year 1. A deeper analysis of the figures above would reveal that the company incurred significantly high cost of sales and operating expenses in Year 2.
The higher the net profit margin (or return on sales), the better. A high percentage means that the company did well in managing its expenses. It is also useful to compare it to a benchmark, such as industry average or past performance, to determine the company's standing.
Net profit margin (NPM) or Return on sales (ROS)
