Importance of Net Profit and Net Margin

Net profit and net margin are two of the most important business metrics. It is essential that they be clearly understood and interpreted.

Net Profit & Net Margin Defined

Net Profit is the bottom line after deducting all expenses of the company. The formula to calculate net profit is:

Net Profit = Sales–(COGS + Operating Expenses + Other Income & Expenses + Taxes)

In the formula above COGS is the abbreviation for for Cost of Goods Sold. For clarification, revenue is sometimes used instead of the term sales, and in the formula above other income & expenses includes interest expense and interest income.

The formula to calculate net margin (which is expressed as a percentage) is:

Net Margin = Net Profit / Sales

It’s Not Always What it Seems

Take a look at these hypothetical income statements for Company A and Company B for three separate years. You will see that some interpretation is needed:
net margin analysis

YEAR ONE COMMENTS

Notice for the first year that everything is the same for both companies except for the COGS. Because Company B has managed to obtain a lower COGS they end up with a net profit of $210,000 and a net margin of 2.10% versus a net loss of $200,000 and a net margin of -2.00% for Company A, even though Company A’s loss caused it to incur no income tax. This demonstrates the importance of controlling your cost of goods sold.

YEAR TWO COMMENTS

In the second year both companies have the same sales, but Company B has been able to maintain the same 40% COGS while Company A saw COGS increase from 45% of sales to 50% of sales. Operating expenses and other income and deductions are the same for both companies. Notice that although Company B has a much larger income tax expense than Company A, because of its higher pre-tax profit it still manages to have a better net profit of $1,820,000 versus $980,000 for Company A. Likewise, its net margin of 15.17% is almost double that of Company A.

YEAR THREE COMMENTS

In the third year everything is the same except that Company B has managed to get a lower income tax rate. This could be a result of any number of tax provisions, such as accelerated depreciation, credits, etc. As a result its net profit and net margin are $2,080,000 and 17.33% versus $1,820,000 and 15.17% for Company A. But there is something all three years also demonstrate.

Pre-Tax Margin

By looking at the pre-tax profit or loss and pre-tax margin we eliminate the impact of income taxes in our comparisons.

Since income tax rates may vary widely by company because of a number of factors, it is helpful to look at results before income tax. As you can see in year one, Company B’s pre-tax profit exceeds Company A’s (who has a loss) by $500,000. This illustrates the impact of controlling the COGS.

In year two both of the companies have the same sales, both have reduced operating expenses to the same level, and both have the same other income and expenses. However, Company B has managed to hold steady with their COGS as a percentage of sales while Company A has seen this grow from 45% of sales to 50% of sales. Again, by looking at the pre-tax profit or loss and pre-tax margin the impact of this is easier to appreciate.

In year three, everything is the same for both companies except for the income tax rate. Again, this rate can vary for a number of reasons, but in order to compare the companies it again helps to consider the pre-tax profit or loss and the pre-tax margin. Here you will see it is the same for both companies at $2,600,000 and 21.67%. Here we can compare the management of operations, while using the net profit or net margin adds in the impact of tax management and tax regulations that may be unique to each company.

Where do You Stand?

Are you tracking you net profit and net margin as well as you pre-tax profit or loss and pre-tax margin? Are you comparing these to other companies in your industry? Just as importantly, are you evaluating this over the years to see if during a growth in sales you are managing your expenses effectively?

If you are a small company without a full-time CFO of Controller it is possible you may not be getting this kind of analysis. The Part-time CFO and Controller services of AimCFO can assist you with this and many other areas.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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