What is Net Profit Margin?
As part of profitability analysis, Net Profit margin or Net Margin (also called after-tax Margin or PAT Margin ) is the most important ratio one must look at. Net profit gives a more conclusive picture of the company’s profitability.
It tells us how profitable was the company after factoring in all the types of expenses ( Direct Expenses, Indirect Expenses, Taxes, etc.).
No matter how profitable the company is at the Gross Profit margin level, if your after-tax profit is very low, then not much is left for Shareholders. Hence, analyzing PAT and PAT margin is crucial.
Net Profit Margin Meaning
Before understanding the meaning of Net Profit Margin, it is important to understand the meaning of Net Profit.
Companies sell goods or services and generate Revenue. But, Revenue is earned only if expenses are incurred. Net Profit or Profit After Tax (PAT) is nothing but the ultimate profit earned by the company after meeting all its expenses. Hence, Net Profit simply shows how much profit is the company finally left with after meeting all of its expenses.
Now, that we have understood the meaning of Net Profit, we are in a good position to understand the meaning of Net Margin or PAT margin
Net Margin means how much Net Profit is the company making on each dollar of Sales. So, it tries to build a relationship with Profit and Sales. If the ratio is higher, it means that the company is generating good profit on each dollar of Sales.
Now, let us bring our focus towards the formula and also try to understand how to calculate the ratio.
Net Profit Margin formula
As given in the image above, the formula for the Net Profit Margin is really simple.
We take Net Profit in the numerator and Net Sales in the denominator.
Net profit can be taken from the Income Statement of the company. It is reported at the bottom just before Earnings Per Share
Net Sales are the sales made by the company after adjusting for any Rebates, Refunds, Discounts etc.
Although finding Net Sales is quite easy, we need to understand how Net Profit is calculated. Look at the below image to understand how Net Profit is arrived after deducting various expenses from the Revenue.
So, to calculate the Net Profit, we simply reduce all types of expenses from Revenue.
Net Profit = Revenue – COGS – Other Expenses – Depreciation & Amortization – Interest Expenses – Taxes
Now that we know how to arrive at Net Profit and Sales, let us look at an example to calculate the ratio practically.
Net Profit Margin Example
Let us look at our 1st example.
We take Alpha Inc and Beta Inc as part of this example.
Values given in the examples below are in $ millions .
Consider the below given income statement for both the companies.
To calculate PAT Margin , we need
- Net Profit
- Net Sales
Net Profit for both the companies can be obtained from the above-given Income Statement. We need to deduct all expenses like Cost of Sales, Other Expenses, D&A, Interest Expenses, Income Taxes.
After deducting all expenses from Revenue of respective companies, we get below Net Profit.
- Alpha Inc= $1,120
- Beta Inc= $350
Looking at the Income Statement, we can easily calculate the Sales for both the companies.
- Alpha Inc= $4,000
- Beta Inc= $3,000
Now that we have both the numerator and the denominator, we can calcualte the ratio easily.
Net Margin = (Net Profit / Net Sales) * 100
- Alpha Inc= ($1,120 / $4,000) * 100 = 28%
- Beta Inc= ($350 / $3,000) * 100 = 12%
What it means that Alpha Inc was more efficient in managing its expenses so that it could generate higher Net Profit on each dollar of Sales
In the case of Beta Inc, the company could not keep its expenses under control as a result of which, it ended up with only 12% Net Profit Margin.
One could compare the expenses for both the companies and see that in the case of Beta Inc, the Cost of Sales was almost 50% of its Revenue. While for Alpha Inc it was only 25%. Hence, clearly the because of this reason, Alpha Inc managed to earn higher Net Profit Margin
Net Profit Margin for Walmart Inc
In our next example, let us calculate the ratio for Walmart Inc using Excel.
You can download the Net Profit Margin Excel template for Walmart using below option.
Once you download, you can see the below Income Statement.
Calculation are similar to what we just saw in our hypothetical example.
We need to look at the bottom part of the Income Statement to know the Net profit. As highlighted in the image above, the Net Profit for the company for the year ending 31 Jan 2020 is $15,201. This amount is arrived after deducting all types of expenses borne by the company as part of its operations. ( Cost of Sales, Depreciation, Interest Expenses, Income Taxes etc)
Net Sales can be easily obtained from the Income Statement. It is reported at the very beginning. The Revenue for the company for the year ending 31 Jan 2020 is $523,964
As we have both the values, we can calculate the ratio now.
Net Profit = $15,201
Net Sales = $523,964
Net Profit Margin = (Net Profit / Net Sales) * 100
Net Profit Margin = ($15,201/ $523,964) * 100 = 2.9%
As clearly evident, Walmart has a low single-digit Net Profit Margin of 2.9%. What this indicates is that on every $100 worth of Revenue, the company is left with only $2.9. Historically, the company has been earning low single-digit Net Margin.
It cannot be concluded that the company is not doing well merely on the fact that the company has a low Net Margin. We need to look at other players in the similar sector to understand if such a low profitability ratio is industry-specific or company-specific.
Net Profit Margin Interpretation
High Net Profit Margin
- If we have a high Net margin, it clearly indicates the company is making high after-tax profits on each dollar of Sales.
- Companies may have a high PAT margin because they may be highly profitable at the Operating profit margin level itself, resulting in a high Net margin.
- It also indicates the company is efficient in managing most of its costs (right from Cost of Sales, Employee Costs, Depreciation, Interest Cost and even Income Taxes)
- Generally, companies who have high Gross Profit Margin will translate its Gross Profit into Net Profits by controlling intermediate expenses like Employee Costs, Interest Cost, Depreciation, etc. Hence it shows better intermediate cost management
- At times due to pricing power and low competition, companies enjoy high profitability. Hence, high Net Profit may also indicate the company may be operating in such an industry where it has either Pricing Power or Low Competition.
Low Net Profit Margin
- Low Net Profit is generally a result of poor cost control. It is an indication of the deteriorating performance of the company. If the company continues to report lower and lower PAT margin, not much value addition happens to the Equity Shareholders
- The company may have huge Borrowings on its Balance Sheet leading to Interest Cost. If the Operating Profit margins are low along with high-Interest Cost, then such companies are prone to report low Net Profit Margins.
- If the company is neither able to increases its Sales Price nor control costs, it will invariably lead to lower Net Profit and lower margin.
How to improve Net Profit Margin
Net Profit Margin can be imporoved in 2 broad ways.
- Increase Sales Price
- Control Costs
Increase Sales Price
Whether the company can Increase its Sales Price warrants analysis of below aspects
- Pricing Power
- Product differention
- Industry Competion
- Competion Structure ( Monopoly, Duopoly)
- Government regualtion
- Elasticity of Demand for company’s product/service
Not all companies enjoy pricing power or competitive advantage. under such a scenario, the company must resort to cost control to improve Net Margins. It can be achieved at various levels like Gross Profit margin level, EBITDA margin level, Operating Profit margin level, etc.
Various types of expenses can be controlled by below mentioned ways
- Access to cheaper and similar quality Raw Materials
- More efficient and economical production process
- Acquiring the right talent at a cheaper price to save Employee Expenses
- Funding the business with lower Borrowings to keep Interest Expenses at minimal
- Utilizing assets at their optimal level i.e, trying to improve Asset turnover ratios
- Performing better tax planning to avoid paying hefty taxes to governments
Gross Profit Margin to Net Profit Margin- Facebook Case Study
One of the best example on the Wallstreet is how Social Media Gaint, Facebook manages to translate its high Gross Profit Margins to Net Profit Margins.
We have performed a detaield analysis of vaious profitability ratios for Facebook from 2015 to 2019.
In the image below, we have depicted the Gross Profit margin, EBITDA margin, Operating Profit margin, Pretax profit margin and finally Net margin.
What is worthwhile to observe is that the company like Facebook is the market leader in Social Media Advertisement industry. Because of low competition, the company earns a Gross Profit margin in the range of 80% to 90%. Although other companies may also earn such a high GP margin ratio, not all companies can translate it to bottom line.
In the case of Facebook, GP margin in 2015 was 84%. But, as we move down into Income Statement, the company was left with only 24% PAT margin. Since the company did not have incremental costs as it scales up, Facebook was able to increase its operating margins resulting in increased PAT margin.
Comparison with similar companies
In analyzing any Financial ratio, apart from looking at the company level, we also need to look at how the ratios are for other similar companies.
In series of images below, we try to compare the Net margin profile for various companies in diverse industry.
Walmart vs Home Depot vs Amazon
We have seen that the margin profile for Walmart is in the low single-digit. But, this is more of a company-specific issue since other company like Home Depot reports relatively higher Net Profit Margin.
Let us look into these margin profile in detail.
As part of explaining the formula with example, we calculated the PAT Margin for Walmart. The ratio was as low as 2%.
But, compared to 2018, there is an increase in the margin during 2019. Baring this increase, the ratio has been in the range of 1%-4%.
In contrast to Walmart, the margin profile for Home Deport is relatively better. The company’s margin is in the range of 8%-10%. This is mainly possible because of the relatively high Gross Profit Margin compared with Walmart.
The company not only has a high margin but also it is able to increase it over the period. The margin increased from 8% during 2015 to 10% in 2019.
Facebook vs Google vs Microsoft
Now, let us compare the margin profile for US tech companies like Apple, Facebook, Microsoft, Google.
US Electronic Gadgets maker Apple makes Net Profit margin in the range of 20%-23%. The margin profile is pretty stable over the past few years, if not increased. Although the company has high pricing power, the company is unable to increase its Gross Profit margin or Operating margin so as to increase its net margin.
Nonetheless, the company has a built a huge ecosystem for its users, gradually, in the coming days, the company is expected to increase its margins by increasing prices (by offering best in class and differentiated products/services)
Yet another tech gaint, Google also earns Net profit margin in the range of 20%-23%. Althought the company earns a high Gross Margin in the range of 55% to 60%, company also incurs high expenses leading to Net margin in the range of 20%.
Since the company has an ocean of products/services, improving margins with correct business mix is a difficult job. If the company focuses to control costs or increase prices in areas like Advertising and Cloud, we may very well see a margin improvement in the coming days.
The margin profile for Microsoft is quite volatile over the past few years. During 2015-16, the company was able to increase its EBITDA margin from around 26% to 36%. Because of this, even the Net Profit margin jumped from 13% to 23%. Ever since the company is strategically focusing on improving margins.
For the year ending 30 June 2020, the Net profit margin for Microsoft was 31% compared to 15% for the year ending 30 June 2018.
Net profit margin profile – Other diverse industries
It is interesting to note that the US-based oil company earns Net profit margin in the range of 5% to 9%. The margin profile has been quite volatile over the past few years.
As the world moves towards the digital ecosystem, most of the transaction is expected to be done online. In such a scenario, invariably Global payment system companies like Paypal are expected to get benefitted. The effort of the company to increase the margins is not yielding any fruits yet. The ratio is stable in the range of 13% to 15%.
Johnson & Johnson Inc
Johnson & Johnson, US-based Pharmaceutical, Consumer Goods, Medical Device manufacturer earns a net margin in the range of 18% to 20%. Although the company makes around 70% GP margin, but when it comes to the bottom-line, the company is left with only 20% net profit. Since, the company has diverse business verticals, increasing the margins with an optimal business mix will always be a challenge.
It’s really wonderful how US-based electric Automobile company TESLA was able to reduce its losses. As evident in the image above, the company was making significant losses with a negative Net margin in the range of -9% to -15%. The company was burning cash at a higher rate than what it earned on its sales.
Over the past few years, the company was able to strategically sell more cars, keep costs under control resulting in improvement in margins. Although the company is not profitable currently, but the sheer potential of the company is promising Wall Street. We may see sales volumes to continue its upward trajectory and improvement in profitability.
This was a detailed explanation about Net Profit margin as part of Financial Ratios Analysis. Below are few more related suggested resources that you can explore.