What Is Net Profit And How To Calculate It (With Example)
Updated 2 September 2023
When a company wants a better understanding of its financial health, it might calculate its net profit, also called its net income or net profit margin. Net refers to a sum calculated after any necessary deductions, like operational costs, tax costs or labour costs. Understanding net income margins and profits can help business accountants, executives or investors learn how to measure a company's financial health and determine its costs and primary income.
In this article, we define net profit, provide a list of what is typically included, explain how to calculate this value, explore some common challenges of the calculation and compare net and gross profits.
What Is Net Profit?
Net profit or net profit margin is a financial ratio used to calculate the percentage of profit that a company generates from its revenue. More specifically, it is the percentage of a company's total revenue that is left after the company accounts for all of its expenses. These can include product production costs, interest, preferred stock dividends, taxes and operating costs such as rent, employee salaries and utilities.
This profit margin can be a strong indicator of a company's financial health and is often used to evaluate a company's effectiveness in a specific market. Companies can use these calculations to predict future profits and make corresponding decisions about operating costs and overall spending. Public companies typically track these profit margins quarterly and include these calculations in their annual reports and income statements. The average net margin varies significantly across industries.
Components Of This Profit Margin
Included in this profit margin are the variables that make up a company's revenue and expenses. For revenue, sometimes referred to as a company's top line, this includes the total income the company generates via sales of products or services. For expenses, this includes all costs associated with creating the product and operating the business. Some companies may generate substantial revenue, but if their expenses are also high, their net margin may remain small.
Here is a list of the common components of net margins:
Incomes from sales
Specialised service costs
How To Calculate Profit Margin?
Besides understanding what profit margin is and its value for businesses, understanding how to calculate it can be crucial for fully understanding the concept. Calculating profit margin follows a specific formula, regardless of the industry or specific company. Here are the five steps to calculate a company's profit margin:
1. Calculate the company's total revenue
Total revenue refers to the entire sum of money a company earns in the given period. If a company is calculating its total revenue for the first quarter of the year, it adds every revenue source from the first day of the year to the final day of the quarter. For example, if a company calculates its total revenue for the first quarter at ₹5,354,041, this is the number the company's accountants use to subtract expenses and ultimately determine net margin.
2. Calculate the company's total expenses
Calculate the total expenses the company incurs over the given reporting time period. This includes all operational expenses and any other costs a company incurs to remain operational, enhance its operations or produce its products. For example, if the same company calculates a total of ₹850,348 in expenses, the company uses that number as its baseline for calculating net margin. The number is typically lower than the company's revenues, or there is no profit margin. If expenses exceed revenues, the company has a negative profit margin.
3. Subtract the total expenses from the total revenue
Subtract the total expenses from the company's total revenue to calculate net income. Using the example above, you can calculate that the company has a total revenue of ₹5,354,041 and total expenses of ₹850,348, creating a net income of ₹4,503,693. You can stop here and simply use the company's net income as a reference, or you can continue to the next step to calculate profit margin in terms of a percentage. Many companies use both calculations, but it may depend on how you plan to use the calculations. For example, investors might want both numbers.
4. Divide the profit by the total revenue.
To calculate the net margin, you divide the company's profits by its total revenue. This generates a decimal number, which you can then use to create a percentage measurement. Using the same example, you can calculate a decimal number by dividing ₹4,503,693 by ₹5,354,041, which equals 0.84.
5. Convert that decimal number into a percentage
Once you calculate the decimal value e, you can multiply that decimal by 100 to get a percentage. Using the example above, you can calculate that the company has a total net income margin of 84%, meaning that only 16% of its revenue goes towards expenses. A profit margin of 84% is not common, but might be an ideal situation for investors, as it means the company maximises its revenues and minimises its costs, creating a more profitable opportunity for everyone with a stake in the business.
Challenges Of Using Net Income Margin
Here is a list of several challenges associated with using this calculation for your consideration:
The issue of comparability across industries presents a limitation to using net income margin to evaluate a company's success and potential longevity. In industries such as groceries, for example, a high rate of product turnover means that a company can still be successful despite a low profit margin. Industries with lower turnover may generate higher net margin ratios but lower overall revenue due to significantly fewer sales. Companies can best maximise the use of the net margin ratio by limiting performance comparisons to that of similar competitors.
Income or cost outliers
Sometimes, a single cost or income outlier can affect the results of a net income margin calculation. These outliers are typically one-time costs or major purchases, or sudden expected downturns in a market. For example, a manufacturing company might spend ₹100,000 on a new piece of production equipment in the third quarter of the year, increasing that quarter's expenses by ₹100,000 and affecting the profit margin for that quarter. Some companies choose to exclude such items from their net calculations to avoid skewing results. Instead, they may choose to create a different sheet and calculations for these onetime expenses.
Net income margin also has the disadvantage of often existing without proper context. Context shows the environment and circumstances that might affect the final calculation. For example, if a company holds significant debts with high interest but maintains strong revenues, they might calculate a much lower net margin. Net margins might also create a limited short-term idea of a company's financial health, excluding its long-term goals, projected growth and other factors that might improve profitability later. Startups are especially vulnerable to these misinterpretations, as they often have higher initial costs and have not yet established themselves financially.
Net Vs. Gross Profits
To better understand this calculation, consider how it compares to gross profits. Gross profits are the profits a company realises after a primary deduction of its main operational expenses. To calculate the net value, you typically require to know the company's gross profits. Gross profits can provide a general idea of how much profit a company has leftover once its deducts operational expenses like labour and utilities, where net includes all of the company's expenses, even minor ones. Gross profit is typically more of an estimate and shows the short-term profitability of a company, whereas the value for net is more specific.
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