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The net profit margin formula looks at how much of a company's revenues are kept as net income. The net profit margin is generally expressed as a percentage. Both net income and revenues can be found on a company's income statement.
One mistake a company or investor may make is to equate company growth, or an increase in sales, with a proportionate increase in profits. This does not take into account the costs associated with the growth of a company. As a company grows, its expenses will at times grow along with it, perhaps at a greater rate than sales. As the expense of a company rises, the net profit margin may shrink. Even attempts to compensate the added expenses with an increase in the sales price of the product, may result in a decrease in the quantity of sales as consumers may not be as willing to purchase the product at the higher price. If this were to happen, total revenues could decrease despite the increase of price per product.
In some situations, the opposite may happen as the cost of production could decrease as production increases.
Although these issues are primarily related to other financial and economic concepts, it is important for a company to apply this formula to monitor its net profit margin as the company changes.
A company's income statement shows a net income of $1 million and operating revenues of $25 million. By applying the formula, $1 million divided by $25 million would result in a net profit margin of 4%. Although the formula is simplistic, applying the concept is important in that 4% of sales will result in after tax profit.