As a small business owner, you'll want to be able to calculate your profit margins to understand the financial health of your company. Profit margins represent how profitable your business is from three separate contexts - gross profit, operating profit and net profit. The net profit margin measures your company's profitability by taking into account all additional income streams and deducting all expenses, including taxes.
In this article, we will review what the net profit margin is and how to calculate it.
What Is Net Profit Margin?
The net profit margin is a metric used to measure a company's overall profitability. It represents the amount per dollar or the percentage of profit that a business retains after accounting for all expenses. Below is the simplest variation of the net profit margin formula:
|Net Profit Margin|
However, if you're currently looking at receipts and records, you'll need to add business income and proceeds from other revenue streams first. From there, deduct all expenses to get your net income figure. Business expenses include the cost of goods sold (COGS), operating costs, non-operating costs and taxes - more on this below.
What's the Difference Between Net Profit Margin and Gross Profit Margin?
The difference between these two metrics is that the net profit margin represents the company's overall profitability. In contrast, gross profit margin measures the percentage of revenue left after accounting for production costs, without factoring in any other expenses. The cost of production only includes expenses incurred in the making of products, such as raw materials, labor, equipment rental and utilities.
However, one indicator is not preferable to another. As a business owner, you'll be able to make informed decisions for your business if you know how to calculate both and what each margin means.
The following formula is for the gross profit margin:
|Gross Profit Margin|
The gross profit margin represents how much your company keeps for every dollar of revenue after paying for the cost of production. For instance, suppose you sell jewelry that you make. Assume a sales revenue of $50,000 for the last year with a $15,000 cost of production.
|Gross Profit Margin|
Your gross profit margin for the year would be 0.70. This means for every dollar of revenue, your profit after accounting for the cost of goods sold is 70 cents. Note that your gross margin profit is further reduced by operating expenses, non-operating expenses and taxes.
Since the gross profit margin calculation excludes any other expenses except for the COGS, you can use it as a starting point for pricing your products or services. Knowing your profit margins also allows you to track and compare both. If your business has a high gross margin, but your overall net margin is relatively low, you might want to look into your operating costs and non-operating expenses and see where you can reduce them.
How to Calculate Net Profit Margin
Here's the formula for net profit margin:
|Net Profit Margin|
As stated at the beginning of this article, you can find this information on your company's income statement. However, if you don't have an income statement, you can quickly calculate your net income with this template:
|− Operating expenses|
|− Other expenses|
|= Net Income|
Determine whether you want to calculate your net income for a month, a quarter or a year, and gather your receipts and records for that specific period. The following sections will walk you through each step of the equation.
Determine Your Total Income
Three elements make up your business's total income: sales or revenue, income from other sources of revenue and extraordinary income. Go through your records and invoices and only include income for the specific period you determined.
- Sales or revenue: This refers to any business income from your regular operations. This will be your net sales after accounting for returns and discounts. For instance, if you sell one product, you can calculate sales by multiplying the number of units sold by the price per item.
- Other streams of revenue: This refers to any income your business receives from other sources, such as investment income or interest income. Be careful not to include any investment income you received in your name. It will be entered in the calculation of your personal income tax, but it will not be part of your business income.
- Extraordinary income: This accounts for money not earned from operations but may occur as part of running a business, such as proceeds from the sale of assets.
Determine Total Expenses
To calculate your company's net income, you have to account for all expenses. Separate your receipts and record expenses according to the following classifications:
- Cost of goods sold: This includes direct costs of production only, such as raw materials, direct labor, equipment cost or rental, and utility expenses for the production site.
- Operating expenses: This refers to ordinary and necessary expenses incurred on day-to-day business operations. Examples include rent, utility expenses, computers, equipment, office furniture, salaries and wages, advertising expenses, insurance costs, depreciation and amortization.
- Depreciation and amortization: These are expenses that apply to assets with useful lives of more than one year. Calculate depreciation for fixed assets like computers, tools or vehicles. Amortization applies to intellectual properties like patents, trademarks and copyrights. Check the Internal Revenue Services (IRS) for more on depreciation and amortization.
- Interest expense: This is the interest you paid for any business loans.
- Extraordinary expenses: These are not considered ordinary and necessary expenses but may occasionally occur as part of owning a business. Examples are losses from the sale of assets or lawyer's fees from resolving a client dispute.
- Taxes: This line item includes income taxes and self-employment taxes.
Calculate Net Income
For illustration, let's calculate the net income of a business owner who makes jewelry. These are their business income and expenses from the previous year:
|Proceeds from sale of vehicle:||$4,500|
|Cost of goods sold:||$15,000|
|Website and marketing expense:||$3,000|
|Home office expense:||$6,500|
− Operating Expenses
− Other Expenses
($50,000 + $500 + $4,500)
Is the task of going through your receipts and calculating your net income keeping you from getting the information you need to run your business? Try Skynova's accounting software today. Use the software to send invoices to your clients and upload your receipts for business expenses. Generate financial statements like balance sheets or income statements whenever you need them.
Calculate the Net Profit Margin
To calculate the net profit margin, let's use amounts from the previous example, where net income was $15,000 and total revenue was $55,000:
|Net Profit Margin|
|=||(Net Income ÷ Revenue) x 100|
|=||($15,000 ÷ 55,000) x 100|
What Is a Good Net Profit Margin?
When it comes to profit margins, the general rule is the higher, the better. For most businesses, a 5% profit margin is considered low, 10% is ideal, and 20% is high. However, whether a net profit margin is high or low varies by business model and industry.
Small businesses generally fare better with a higher profit margin. Large companies like Walmart can survive with a lower profit margin because the large number of items they sell make up for the difference. For instance, in January 2021, Walmart's net margin was 2.42%. The ratio was calculated from a net income of $13.51B and $559.15B revenue. Check out this NYU report on U.S profit margins for more information on margins across industries.
Let Skynova Help You Manage Your Small Business Bookkeeping
If you want to spend less time tracking your income and expenses, try Skynova's accounting software for small businesses today! Keep your receipts and records organized in one place. And easily compare your company's profitability margins through automatically generated financial reports whenever you need them.
Notice to the Reader
The content within this article is meant to be used as general guidelines and may not apply to your specific situation. Always consult with a professional accountant for individual advice on creating financial statements for your business.