Net Margin - Understanding the Different Kinds of Profit

Net profit margin forces a company to strip away not just their cost of goods sold (COGS) from revenue, but also other costs such as payroll, rent, interest payments, and taxes. All of these operational expenses, while they may not directly affect cash flow, must be accounted for when determining the financial health of a company.

Investors are looking for a positive net margin ratio that is in line with or above a company’s industry average. As they look over quarters or months, investors will want to see a net margin that is growing, or at the very least remaining the same. If a company is reporting a negative net margin it is a clear sign that they are not profitable and is usually a warning flag for investors. At this point, investors will want to see what steps a business may be taking to boost profitability and their net margin.

Introduction

Every business needs a way to assess if they are making money (i.e. are they profitable?). Every company has an idea, and probably a pretty good one, of how much sales revenue they are bringing in. But after operating expenses, taxes, and other costs are deducted, do they still have money left over? As important as this is for business owners, it’s equally important to investors. After all, when you’re considering investing in one company over another, profitability is a more important metric than revenue.

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One of the clearest ways for a company to measure their profitability is by calculating their net margin. Net margin helps show a company, and potential investors, how much money is making its way to the bottom of the balance sheet.

If you’re ready to understand how to measure the profitability of your business, this article is for you. We’ll explain what net margin is and we’ll review each of the components so you can see how it is different from other measures of profitability.

Understanding the different kinds of profit

Net profit is an easy concept to understand, but it can be confused with other metrics. And using the wrong number for net profit can drastically affect the ratio and give you an incomplete picture of what is happening with a business. Investors can generally find a company’s net profit in the financial statements they provide as part of their earnings report. The net profit is found on the bottom of their income statement and is transferred over to their balance sheet. The net profit margin ratio is also something that most accounting software packages will calculate automatically. Nevertheless, a basic understanding of different profitability measures is an important part of fundamental analysis.

Net profit is different from gross profit– Gross profit is calculated as:

Revenue – Cost of Goods Sold (COGS).

Revenue is easy enough to understand, it’s the net sales a business brings in by selling its goods or services. The cost of goods sold will be different depending on the business. For a bakery, it would be the cost of ingredients (raw materials) that go to make the finished products. It would also include inventory. Service-based businesses would include the time certain individuals spend with their clients.

Gross profit can help a business figure out a proper pricing model for their product. In our example, if the bakery experiences an increase in the cost of the ingredients needed to make their product, such as an increase in the price of sugar or cocoa, they may have to raise their prices in order to maintain a profit margin. Manufacturers who depend on raw materials such as steel to make their products will see profit margins decline if the price of those materials rises.

Cost of goods sold is not the only cost of doing business– Any business owner knows that their gross profit number is not the actual number that impacts their personal wealth. There are other operating expenses in addition to other costs such as payroll, interest payments, and taxes that have to be paid from the revenue that comes in. Let’s take a look at what each of these might entail.

Operating expenses are considered as any cost associated with your business that is not part of the cost of goods or services sold. These indirect costs include a broad range of expenses such as overhead costs such as payroll and rent and other costs such as depreciation and amortization, and loan payments. These may be annual, quarterly, or monthly. This information is found on the financial statements that companies provide in their earnings reports.

Remember cost of goods sold is defined as only those direct costs that a business can fully attribute to the production of their product or service. This can get a little blurry in certain cases. For example, if a business has an employee who spends only a portion of their time assembling the product, the company can write off that percentage of his salary as part of the COGS formula. Otherwise, it would be considered an operating expense.

Interest and taxes– this means all taxes (federal, state, local, and payroll) plus any interest payments on business debt – such as a business loan.

Once a business has subtracted all those expenses, they have their net profit.

Calculating net profit and net profit margin ratio

Here’s an example of how all of these figures come together.

Bonnie’s Bakery had monthly revenue of $200,000.

Their COGS was $75,000

They had operational expenses that totaled $50,000

Their monthly interest and tax payments were $10,000

Their gross profit would be: $200,000 - $75,000 = $125,000

However, their net profit would be: $200,000 – ($75,000 + 50,000 + $10,000) = $65,000

And their net profit margin would be: $65,000/200,000 = 0.325 or 32.5%

Limitations of net margin

The same limitations apply to net margin as with other ratios. First, a company’s net profit margin has to be looked at in the context of their entire industry. Certain industries will naturally have a higher COGS or may have other operational expenses that are typical for that industry. In that sense, any net profit number needs to be looked at in terms of the industry as a whole. Is the company’s net margin significantly higher (good), lower (bad) or in-line with other businesses in the industry?

A second limitation is that a company’s net profit margin should be studied over time. This is important because a company may experience seasonal sales fluctuations or one-time costs that can skew the number in one direction or another. Seeing how a company’s ratio changes over several earnings periods, or even years, will give investors a better sense of the company’s overall health.

Many analysts would also say that cash flow is more relevant to determining the health of a business. Maintaining a positive cash flow means that more money is coming into your business than is going out of it at any moment in time. This is important, however, because a business could find themselves as having a positive cash flow without being profitable, or conversely having a negative cash flow but still showing a profit. Investors should check a company’s cash flow statement which is typically among the financial statements provided by a company during earnings season.

Ways companies can increase net margin

When you understand the formula for net margin, there are only a few logical ways for a business to increase their net margins.

1. Increase their revenue – this seems obvious, but what may not be so obvious is that the business should be increasing their revenue without increasing their other expenses. While there is truth to the phrase, “you have to spend money to make money”, if that is done over a long period of time it is a sure-fire route to insolvency. Have you increased prices recently? Maybe your competitors have raised their prices and your products are looking “cheap” by comparison. However, cheap may not always be good because the right price for a product is what the market will bear.
2. Decrease their cost of goods sold (COGS) – this is another obvious solution, but it may not be easy to do. Nevertheless, sometimes businesses can get so caught up in the day-to-day that they don’t look at things like their supplier costs to see where they might be able to find savings. Each individual expense may seem insignificant on its own, but put together could mean big savings.
3. Pare Operating Expenses – these can be harder to find, but businesses do this on a regular basis to determine such things as if their employee productivity matches their salary or if their marketing efforts are generating the ROI they expected.
4. Find savings on interest rates and look for ways to reduce taxes – This may include something as simple as refinancing multiple business loans into a single loan. On the tax side, even large companies with their own large accounting departments rely on outside tax professionals to help ensure they get all the deductions they are entitled to receive.

It’s important to mention that when you’re analyzing a company as an investor, it’s different than looking at through the eyes of a consumer or an employee. Hearing a corporation announce layoffs or price increases can be negative or positive. Generally speaking, a company will announce layoffs and other actions as a way to head off problems from hitting their bottom line. This is because they are beholden to their shareholders to provide value. Failing to take necessary actions can result in a loss of confidence by shareholders which will have additional negative consequences for the business.

The final word on net margin

Net margin (also known as net profit margin) is one of the more basic ways to measure the profitability (and therefore success) of a business. Net margin strips all the costs that eat away at revenue to establish a bottom line number. The formula for net margin is:

Net margin = Net profit/Total revenue

Net profit is different from gross profit because it includes costs such as operating expenses, interest payments, and taxes that are not accounted for in the formula for gross profit which only subtracts the cost of goods sold (COGS). Net margin (also called net profit) is found on a company’s income statement and balance sheet.

While what constitutes the “right” level of net margin will be different for different industries, investors should look for positive margin and ideally a margin that is growing over time. Net margin is one of many metrics that an investor should consider before deciding to invest.

If a company does have a net margin that is lower than their competitors, investors should do more research to determine what actions the company may be taking to improve their net profit margin. In some cases, these actions (such as price increases or layoffs) may not be welcome by the general public but are critical to the long-term success of the business. If a company continually has to take these actions, however, it may indicate a larger problem with their business model.