When you own a business things can get a little crazy. You’ve got inventory to control employees to manage and finances to keep in order. It’s important to understand all of the different financial terms that show up on your reports or those numbers aren’t going to mean much to you. I know from experience that when you see the word profit and the number looks, well, stately, you can somehow forget all of the money you’ve already spent and all of the money you have yet to spend. April 15th rolls around once a year and we all dread doing our taxes. Just don’t forget that even though your net sales figure is looking good – you’ve still got dues to pay. A net profit ratio, or net profit percentage is the ratio of after-tax profits to your net sales. In other words, it’s your profit margin.
I know financial reports can seem overwhelming and hard to interpret, but don’t let that keep you from understanding vital accounting procedures that can make or break you. This Financial Accounting Introduction should help ease your fears.
The formula for the net profit ratio is:
Net Profit Ratio = net profit/net sales
If you need your ratio in percentage form then multiply the product by 100.
What are net sales?
As a business owner you have a lot of number to look through on a weekly, monthly, quarterly and annual basis. There’s the net sales, gross sales, gross profit, deductions and expenses to account for (and many more – understand more about business bookkeeping in Learn Accounting). Your net sales figure is a good indicator of how your business is doing and if you’re selling prices are reasonable and practical for your profitability. On your financial reports you’ll notice there are total sales (or gross profit) and net sales. Net sales are a more accurate summary of the money you are making rather than the money you are just putting in the cash register (total sales). See, the net sales can be calculated by subtracting the cost of goods from your total sales profit.
Often time, business owners provide credit discounts or return policies that may affect their profit as customers pay off debts sooner than allotted and they return items after purchase. The net sales total also figures in damaged goods, and unfortunately, stolen goods. While you may have made $10,000 total this month, after deducting your expenses for purchasing the goods to sell, damages and so on, your net sales may be more like $7,000.
What is a net profit?
The net profit is the total amount of money going in your pocket. Say you made $10,000 in total revenue for this month, but you have to factor in customer returns, damaged goods, operational expenses, cost of goods and taxes. You may only end up with around $1,500 after making all of the necessary deductions. Therefore, $1,500 would be your net profit and you can celebrate because you’re not in the red. Check out Business Financing for Entrepreneurs for some finance advice, capital management tips and the fundamentals of accounting for your business.
So now that you know what a net profit is and what net sales are, let’s plug the example numbers into the net profit ratio equation to see what we get.
Total revenue: $10,000
Sales Returns: ($3,000)
Net Sales: $7,000
Net Profit $3,000
$1,500/$7,000 = 21.42% (Net Profit Ratio)
This is a relatively high net profit ratio. Something to keep in mind is this particular ratio is really a short term measurement as it doesn’t explore what actions the company is taking to maintain or increase profitability. For example, a company may employ a low pricing strategy to increase its share of the market. In doing so, the company may have a smaller net sales number which directly affects the net profit ratio. However, this ratio may not be a true indicator of the company’s performance because of their strategy to increase business. The reverse is also true, if a company decides to play to a niche market and has higher priced goods, the net profit ratio may seem extraordinarily high, but their market remains very small. There are other more reliable ratios you can calculate to help you understand your selling price to cost of goods like the gross profit ratio.
There is a good article on important Accounting Ratios that can indicate how your business is performing if you want more information.