What net profit margin tells you
Net income is the bottom line of the income statement. It is what remains of revenue after cost of goods sold, operating expenses, interest, income tax and any other gains or losses for the period. Revenue is net sales for the same period. The ratio is also called net margin, profit margin or return on sales.
A result of 12% means the business kept 12% of its revenue as profit once every expense for the period had been recorded. A negative result means the business made a loss.
Reading a high or low result
Net margin is shaped by everything above it on the income statement: pricing, direct costs, overheads, the cost of borrowing and tax. That makes it a useful summary, but on its own it does not tell you why profit changed. When it moves, check the gross and operating margins to find where the change came from.
- A higher margin can come from better pricing or cost control, lower interest costs, a lower tax charge, or a one-off gain such as profit on selling part of the business.
- A lower margin can come from rising costs, heavier borrowing, a higher tax charge, or a one-off loss such as an impairment. Some businesses also accept a lower margin on purpose in exchange for higher sales volume.
What is normal varies widely by industry and business model. Compare the margin with earlier periods of the same business, or with similar businesses.
What the margin does not show
- It mixes operating results with financing and tax. Two businesses with identical operations can report different net margins because one carries more debt or pays tax at a different rate.
- Net income is an accounting figure, not cash. It includes noncash charges such as depreciation, and it records income when it is earned rather than when it is received.
- It does not show how much capital the business used to earn its profit. Return on assets relates profit to the assets employed.
Common mistakes
- Ignoring one-off items. Check what net income includes, such as gains on asset sales, impairments, restructuring costs or results from discontinued operations.
- Mixing periods, for example net income for one quarter with revenue for a full year.
- Treating net income as cash the business has available to spend.
- Comparing businesses with very different debt levels or tax positions on net margin alone, without looking at operating margin as well.
Related measures
Operating profit margin measures profit before interest and tax, which removes much of the effect of financing and tax differences. To see how net margin relates to the first profit line on the income statement, read gross vs net profit margin. Net margin is also the first of the three parts of DuPont analysis, which combines it with asset turnover and leverage to explain return on equity.