Profit margin is a great metric to gauge the success of a business. A proper analysis of this metric reveals how well a company is run and/or what are its headwinds.
Net profit margin is the most effective way to measure a company’s profitability. It is derived by deducting all operating and non-operating expenses as well as income tax payable to the government from revenues.
Net Profit Margin = Net profit /Sales * 100.
In other words, net profit margin calculates net profit of a company for each dollar of sales.
Net Profit Margin: Pros & Cons
Net profit margin gives us a glimpse into the company’s business model in terms of pricing policy, cost structure and manufacturing efficiency. Therefore, a proper analysis of net profit margin discloses how efficiently a company is running its business and controlling costs.
However, net profit margin has a number of flaws that limit its scope as an effective analytical tool. Its calculation widely varies from industry to industry. Difference in accounting treatment of various items – especially non-cash expenses like depreciation and stock-based compensation – makes it a difficult metric for the purpose of comparison.
Further, for companies preferring to grow with debt, instead of equity funding, higher interest expense usually drags down the net profit. In such cases, it is not an effective tool to analyze the company’s performance.
The Right Strategy
In most of the times, a healthy net profit translates into solid earnings per share (EPS), which is the single most important metric that defines a well-run business. Indeed, healthy net profit margin and solid EPS growth are two of the most sought after ingredients in a business model.
