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Financial Accounting: Help and Review18 chapters | 235 lessons

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Lesson Transcript

Instructor:
*Tara Schofield*

This lesson discusses the importance of the net profit margin. The formula is explained and an example is provided that walks through the steps of calculating net profit margin.

**Net profit margin** is a key factor in determining how financially strong a company is. It is a ratio that explains how much of the money a company earns showing how much of each dollar earned is retained by the company.

Because net profit margin is a measurement of income, the higher the net profit margin, the better. When comparing a company to its competitors, the best thing is to have a higher net profit margin than other companies in the industry. The higher the net profit margin, the better, meaning that for each dollar earned, a higher percentage of that dollar is kept for the business.

By comparing the net profit margin of his or her business to the industry standard or competitors' net profit margins, a business owner can make the best decisions and adjustments that allow the company to be more successful. It also helps find weaknesses or areas that can be improved in expense management.

Before the net profit margin can be calculated, we need to know the net profit and revenue numbers. Revenue is the amount of money or income a company earns from normal business operations. **Net profit** is the amount of money left from the money (revenue) that comes into the business after the general expenses, manufacturing costs, interests, and taxes are paid.

There are two steps involved in the calculation of the net profit margin. The first step is the calculation of the net profit. Let's start with that calculation. The net profit is the amount of revenue left over after subtracting the cost of goods sold, otherwise known as COGS; the operating expenses; and the deduction of interest paid and taxes as well.

The formula for net profit looks like this:

**Net profit = Revenue - Cost of Goods Sold (COGS) - Operating Expenses - Interest and Taxes**

Once we have the net profit and revenue numbers, we can calculate net profit margin. The **net profit margin** is the net profit divided by the revenue.

**Net Profit Margin = Net Profit / Revenue**

Let's walk through this with an example. You own a bicycle shop in a town that has two other bicycle shops. To find how your business is doing financially compared to the other shops, you need to know how you are doing, compared with the others in town. After doing some research, you find that the other bicycle shops have a profit margin in the 19% - 22% range. However, you aren't sure if your business is more profitable than those shops are or not. That's where our calculations come in.

Last year you had a great year. The bike shop earned $250,000 in revenue. The bikes and materials cost $109,000. This is your cost of goods sold, or your COGS, amount. When you add together your other costs, operating expenses for the shop were $17,500 and interest and taxes were $21,200. You have all of the information you need to calculate your shop's net profit margin. Here we go.

First, we need to know the net profit. Let's plug your bicycle shop numbers into the formula:

**Net Profit = Revenue - Cost of Goods Sold (COGS) - Operating Expenses - Interest and Taxes**

Net Profit = $250,000 - $109,000 - $17,500 - $21,200

Net Profit = $102,300

We know revenue is $250,000, so we are now ready to calculate our net profit margin:

**Net Profit Margin = Net Profit / Revenue**

Net Profit Margin = $102,300 / $250,000

Net Profit Margin = 40.9%

The net profit margin for your bicycle shop is nearly 41%. Wow! Your shop is considerably more profitable than the competitors' shops because their net profit margin was only in the 19% - 22% range. You are about twice as profitable as either of those shops. This means their revenue is substantially lower than your revenue or their expenses are much higher than yours - or a combination of both.

Let's do a quick review of the main points. Knowing a company's **net profit margin** gives a great snapshot into the profitability of a company. It is a number that represents how much money is left after the expenses of the business are covered. The goal of any company should be to have a higher net profit margin. If you know the standard net profit margin of your industry, you can compare the success and profitability of your business to the industry standard. If it's higher than the industry standard, your business is doing great.

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Financial Accounting: Help and Review18 chapters | 235 lessons

- The Differences Between Accrual & Cash-Basis Accounting 6:20
- Using Accrual Accounting to Make Financial Statements More Useful 5:47
- Accrued Expenses & Revenues: Definition & Examples 4:30
- Preparing Financial Statements 7:35
- Temporary & Permanent Accounts: Definition & Differences 4:57
- Real Accounts vs. Nominal Accounts: Definition, Differences & Examples 4:55
- Debt Financing: Definition, Types, Advantages & Disadvantages
- Deficit Financing: Definition & Concept
- Differential Cost in Accounting: Definition, Analysis & Formula 5:21
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- How to Calculate Interest Expense: Formula & Example 4:31
- How to Calculate Internal Rate of Return: Definition & Formula
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- How to Calculate Net Profit Margin: Definition & Formula 4:58
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- How to Calculate the Return on Equity: Definition, Formula & Example 3:31
- How to Calculate Yield to Maturity: Definition, Equation & Example 5:14
- Unearned Revenue in Accounting: Definition & Examples 4:46
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