Profitability ratios are the cornerstone of investment decisions concerning stocks. It provides an understanding of a company’s financial performance and somewhat indicates its potential for prospective growth. In that realm of metrics, net margin is one such important profitability ratio.
What is Net Margin?
As mentioned above, it is a profitability ratio that analysts use to determine how much net profit a company generates against one rupee of its revenue. Therefore, it is also called net profit margin.
In other words, the net margin ratio denotes the relationship between a company’s or business’s net profits and total revenue. Therefore, if a company’s net margin is 50%, it realises a net profit of Rs.0.5 against each Re.1 of revenue.
Nevertheless, to understand the criticality of net margin, individuals must be well-conversant in what net profit represents for a company. Net profit or income refers to that share of total revenue left after accounting for all kinds of costs there could be, like taxes, depreciation, cost of goods sold, et al.
Ergo, a company is typically at the liberty of using said net income for capital investments, infrastructure improvement, or stowing them in retained earnings. A net margin is, therefore, an archetypal metric for drawing comparisons between companies in the same industry.
How to Calculate Net Margin?
Calculation of net margin typically begins with computing the net income of the concerned organisation. However, it might ease the stress to know that companies publish their financial reports periodically, which states the net income as a separate item in the Income Statement.
Nevertheless, to calculate net income individuals need to deduct the following items from the total revenue –
- Cost of goods sold.
- Cash outflow pertinent to a specific accounting period.
- Administrative overheads like salary.
- Research and Development expenses.
- Interest on debt.
Note: In some financial reports, the total net sales heading is used in lieu of total revenue.
Following net income computation, individuals can calculate net margin using the following formula –
Net Margin = (Net income / Total revenue) x 100
It shall be noted that the net profit margin can be either negative or positive, depending on the net income. Simply put, a negative net margin portrays unprofitability for the specific period.
ABT Ltd. has released the following data on its financial performance for FY 2019 – 20 –
- Total revenue: Rs.10 lakh
- Raw materials consumed: Rs.50,000
- Wages: Rs.50,000
- Administrative costs: Rs.2.5 lakh
- Depreciation: Rs.75,000
- Interest: Rs.25000
- Income tax: Rs.20,000
The following table illustrates the calculation of net income.
|Interest on debt||(25,000)|
As per net margin formula,
(Net income / Total revenue) x 100 = (530000 / 1000000) x 100 = 53%
Therefore, ABT Ltd. could retain Rs.0.53 of net income against Re.1 of its total revenue.
The following is the Profit and Loss Statement of Hindustan Unilever for the Financial Year 2019 – 20.
|Particulars||Amount (in Crore)||Amount (in Crore)|
Therefore, the net margin of Hindustan Unilever for Financial Year 2019 – 20 stands at:
Net margin = (6738 / 39518) x 100 = 17.05%
How to Interpret Net Margin?
As mentioned and demonstrated, a net profit margin is telling of a company’s financial health after all expenses and obligations have been accounted for and deducted from its total revenue. It brings forth certain applications of the net margin ratio.
- Assessing the competence of financial measures
By comparing net margin ratios of different accounting periods, companies can assess whether their financial measures are bearing fruit. In the absence of extraordinary events, companies can also project their net income based on revenues by tracking their net margin ratios over time.
- Comparison between companies of different sizes
Another critical way in which it can be applied is to draw comparisons between companies with varying market capitalisation sizes. However, it must be noted that is only useful when contrasting companies from the same industry. That is because the net margin varies from industry to industry.
While some industries exhibit double-digit net margins, others might be within single-digit ones. Case in point, the apparel industry sports an average net margin of 6% while the broadcasting industry boasts an average net margin of 30%.
- Management of costs
Reviewing the net margin of a company across several periods can illustrate how well it is managing its costs against that of revenue generation. For instance, if the total revenue of a company is increasing at a slower pace compared to its total expenses and obligations, then the net margin will contract over time. It suggests that said company cannot manage its cost-efficiently enough.
One critical limitation of net margin is that it does not suffice as a standalone metric to determine a company’s profitability, managerial competency, and the likes. Therefore, individuals need to use other metrics such as gross margin and operating profit ratio in conjunction with it for better-rounded inferences.
Net Margin vis-á-vis Alternatives
Individuals can use the gross margin to understand trends of COGS of an organization and determine its profitability strictly within the production scope. In conjunction with the net margin, it can tell about the efficiency of a company’s cost-containment measures over time.
Individuals can also use metrics like the Price-to-Earnings ratio to gain an idea about how much investors are willing to invest for Re.1 of its earnings. When comparing companies, the P/E ratio can be used alongside net margin.