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Net profit margin
or Return on sales

Checked for updates, April 2022. Accountingverse.com

What is Net Profit Margin?

Net profit margin (also known as “return on sales”) is a profitability ratio that measures the percentage of net income to sales.

Comparing net income of two different periods or two different companies using the dollar values can sometimes be inappropriate because of size differences.

The use of net profit margin negates the effect of size for better analysis of an entity’s performance.

Net Profit Margin Formula and Explanation

Net profit margin makes use of information presented on the income statement.

Net profit margin (return on sales) is computed using this formula:

Net Income ÷ Net Sales

It is important to note that "net sales" is used in the computation. Net sales is equal to gross sales minus any sales discounts, returns, and allowances. The use of net sales instead of gross sales makes the computation more accurate as the "true" sales revenue is reflected.

Example

in millions of $ Year 2   Year 1
Gross sales 1,500   960
Less: Sales discounts 12   9
Sales returns and allowances 20   15
Net sales 1,468   936
Less: Cost of sales 1,158   671
Gross profit 310   265
Less: Operating expenses 143   55
Operating income 167   160
Less: Interest expense 9   10
Earnings before tax 158   150
Less: Taxes 55   52
Net income 103   98

Net profit margin (Y1) = 98 / 936 = 10.5%
Net profit margin (Y2) = 103 / 1,468 = 7.0%

Interpreting the Net Profit Margin

The net profit margin declined in Year 2. Notice that in terms of dollar amount, net income is higher in Year 2. Nonetheless, it represents only 7.0% of sales; while in Year 1, it represents 10.5%. For every dollar of sales, the entity made $0.07 in Year 2 and $0.105 in Year 1. Hence in terms of managing costs and expenses, the company did better in Year 1. A deeper analysis of the figures above would reveal that the company incurred significantly high cost of sales and operating expenses in Year 2.

The higher the net profit margin (or return on sales), the better. A high percentage means that the company did well in managing its expenses. It is also useful to compare it to a benchmark, such as industry average or past performance, to determine the company's standing.

Key Takeaways

Net profit margin (NPM) or Return on sales (ROS)

  • a measure of a company's ability to generate income, it shows how much net profit the company makes from sales proceeds
  • calculated as: net income divided by total sales
  • generally, the higher the NPM or ROS, the better. It is a good to compare it with past performance and/or industry benchmarks to better assess if the company is doing better or worse
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Net profit margin or Return on sales (2022). Accountingverse.
https://www.accountingverse.com/managerial-accounting/fs-analysis/net-profit-margin.html
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