Profitability - Net Profit Ratio

What it measures: Profitability (Bottom line)

How profitable a firm is after Cost of Goods Sold and all other expenses have been deducted from revenue; overall performance; profit or loss?

Information drawn from the Income Statement;

Represented as a percentage.

The equation:

Net Profit / Sales x 100

What the result means:

The percentage of every $1 of sales that results in Net Profit. Higher numbers are better for a firm; meaning that they are able to maximise their profits by minimising expenses and maximising revenue.

Lower results indicate the firm is struggling to cover all expenses of operations through the profit margins obtained from sales. Negative results indicate an unsuccessful business. 

The Net Profit ratio can be improved by lifting revenue (more sales, higher prices), lowering COGS (find cheaper supplier) and reducing expenses (efficiency).

Sample Statement:

Net Profit ($45,000) / Sales ($300,000) x 100 = 15%

The firm has a Net Profit Ratio result of 15%. This means that 15% of revenue leads to net profit. This is a strong performance, but must be compared to previous years and industry standards for more accurate comparison.

How to Improve the Net Profit Ratio:

• Lift prices

• Sell less for the same price (shrinkflation)

• Change supplier or negotiate better deal with supplier for bulk purchases (economies of scale - but then need to consider Inventory Management)

• Reducing expenses / improving efficiency.

  • Reduce cost of operations (outsourcing, better technology, lower energy use, less waste and defects, reduce transport / logistics)

  • Reduce cost of marketing OR improve ROI on marketing spend (more sales from less promotional spend)

  • Reduce cost of Human Resources (contracting, downsizing, reduce staff turnover - less recruitment and training expenses)  

Note: Expense reduction is the ONLY difference from the Gross Profit Ratio.

Net Profit Ratio is Negatively Impacted by:

• Competition or price wars (forcing prices down squeezes margins)

• Sales Promotion or Price Penetration strategy (lowering prices to gain sales and market share)

• Suppliers lifting their prices (higher COGS)

• Customer buying power (if a big and powerful customer like Woolworths negotiates a lower price to access their shelves)

• Product Life Cycle in decline (price reduction) 

• Expenses increasing / decreased efficiency.

  • Increase in expenses - cost of operations (energy, higher defect rate, more waste, technology breakdowns, accounting / legal expenses)

  • Increase in expenses - marketing spend (new promotional advertising campaign) 

  • Increase in expenses - Human Resources (labour, rewards programs, training expenses, recruitment expenses)