The accounting ratios are categorised into three main types such as the profitability
ratios. In this video we will particularly look at the net profit margin ratio!
I’m Thomas Harwood and Welcome to The Accounting Student, where we create free and short videos
so that you can learn about accounting.
Today’s video is looking at the net profit margin ratio.
As stated in the previous videos on The Accounting Ratios and The Gross Profit Margin ratio,
that the financial statements such as the income statement and the balance sheet would
be incredibly impractical to all but the highly skilled experts, without the use of the accounting
ratios.
The accounting ratios play a significant role in fulfilling the needs of the users of the
financial statements, and therefore the statements can be clearly understood and be of valuable
use.
Accounting ratios are used to evaluate or compare financial data and will allow the
user to gain an understanding into how a business is performing from one period to another or
how a business is performing against another business.
The accounting ratios can be categorised into three main groups and they are profitability,
liquidity and efficiency.
Profitability ratios look into the profits and returns of the business. And this will
normally be shown as a percentage of the revenue of the business.
The profitability ratios are split further into more ratios which following on from the
gross profit margin ratio which we looked at in the previous video, we have the net
profit margin ratio which is as common ratio in this group.
The net profit margin ratio assesses the relationship between net profit and sales. Unsurprisingly,
as businesses look to achieve a high gross profit margin they will also aim to achieve
a high net profit margin for the entire business and on the products or services they provide.
The process used to calculate net profit margin is parallel to the way we calculate the gross
profit margin. The only difference is that we replace the gross profit with net profit
and then divide this amount by the sales value. The result is then multiplied by one hundred
to get the value as a percentage.
Let’s go back to the previous example in our last video with Tim and his toy shop to
demonstrate the ratio.
Tim owns a toy shop and his main product sold during the year was a rocket ship. The rocket
ship he recently sold was at a sales price of £300 and the gross profit for this rocket
was £60. In the previous video on the gross profit margin, it was worked out that Tim
had made a gross profit margin of 20% on this one rocket.
Now Tim wants to find out the net profit margin. He knows that the other expenses related to
selling the rocket ship was £35.
So first we need to calculate the net profit amount which in this case will be the gross
profit of £60 minus the other expenses of £35 and this gives us a value of £25.
Then we can use the £25 of net profit just calculated and divide this by the sales value
of £300.
By dividing this we get a result of 0.0833 and multiply this by 100 gives us 8.33%.
Therefore, for this rocket, Tim made a net profit margin of 8.33%.
Additionally, from identifying the value of the net profit margin of 8.33% and the gross
profit margin of 20% from the previous video we can work out the expenses as a percentage
of sales.
This will be the two margins taken away from each other. So, 20% subtract 8.33% equals
to 11.67% of expenses.
From looking at this the net profit margin of 8.33% looks very good for the rocket ship
but with the expenses being 11.67% which is over half of the gross profit margin of 20%
this maybe an indicator that the costs of the rocket are not being effectively controlled.
If the net profit value margin did decrease, then management should be concerned. However,
it has been known in business that some businesses can operate with very low margins by having
high sales volumes.
So that was the explanation of the net profit margin ratio. If you enjoyed it, press the
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