What is Net Profit Ratio?
Net profit ratio (also known as net profit margin) is the calculation of net profit after tax as a percentage of net sales.
Formula of Net Profit Ratio
Both the components of the formula (i.e., net profit and net sales) are usually available from trading and profit and loss account or income statement.
Net profit (NP) ratio taken together with return on equity (ROE) ratio, shows how well the company marks up its goods for sale and how well it manages to contain its indirect expenses within the gross profit margin. As explained in the gross profit ratio, certain companies with heavier overheads need to have a higher gross profit margin. If we take gross profit as a percentage of sales (gross profit ratio) and then relate it to the net profit as a percentage to sales (net profit ratio), we can evaluate the efficacy of the company’s pricing policy. If a high gross profit margin does not translate into adequate net profit percentage, one of the reasons may be that higher prices are affecting the sales volume and therefore, the overall profit is dropping. The other reason could be that the indirect expenses (i.e., overheads) are too high in relation to the volume of business handled.
The following information has been extracted from the accounting records of John Trading Concern:
Gross sales: $4,850,000
Sales returns: $50,000
Net profit before tax: $960,000
Corporation tax rate: 50%
Calculate net profit ratio of the John Trading Concern.
Net profit ratio = ($480,000*/$4,800,000**) × 100
*Net profit after tax = 960,000 × 0.5
**Net sales = $4,850,000 – $50,000
The net profit ratio of the John trading concern is 10% which is a good return on sales for a trading concern. However a true evaluation of the management’s efficiency in generating a return on sales is possible only by comparing the ratio with others in the industry or with the industry’s average net profit ratio.