To calculate gross profit margin, subtract the cost of goods sold from a company’s revenue; then divide by revenue. If a company sells goods for $100 and pays $70 to produce those goods, the company’s gross profit margin is 30%.
To calculate net profit margin, take the gross profit and subtract operating and all other expenses, such as taxes and interest paid on debt. Then divide by revenue. If the same company has operating expenses, taxes and interest totaling $20, its net profit margin is 10%.
While gross profit margin provides a general indication of profitability, net profit margin is a more accurate measure. Increases in revenue do not necessarily create increases in profitability. Net profit margin reveals the percentage of revenue that reflects a company’s profit per dollar of sales.
Investors use both ratios to assess a company’s financial health. But net profit margins paint a clearer picture of the overall expenses compared to revenue. Often, companies find it easier to increase profits by reducing costs rather than increasing sales.
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