Ratio analysis is a commonly used tool for performing financial analysis. A company can calculate different types of ratios to ascertain its profitability, long term solvency and short term liquidity position. All these ratios are calculated with the help of information available in the company’s financial statement. Income statement contains information on incomes and expenses of the company.

Balance sheet contains information on the assets and liabilities of the company.  Difference between incomes and expenses reported on the income statement is known as net profit/net loss.

Net profit ratio is one of the most important profitability ratios. Net profit ratio is calculated with the help of information contained in the income statement. In order to accurately calculate net profit ratio, it is important to understand the components used in the calculation of this ratio.

Formula for Net Profit Ratio

Net profit ratio is calculated by dividing the value of net profit with the value of net sales. Both these figures can be directly obtained from the company’s income statement.

Automated accounting systems facilitate automatic calculation of this ratio. Net profit ratio is expressed in a percentage form. Equation for net profit ratio is as follows:

Net Profit Ratio: Net Profit/Net Sales * 100

Meaning of Net Profit

Net profit is the revenue earned by the company after meeting all of its business expenses. In order to calculate this figure, it is important to ensure that all business transactions are recorded appropriately in the books of accounts.

Since all incomes are reported on the credit side of the income statement and all expenses are reported on the debit side of the income statement, a company earns profit only when the total value of credit side exceeds the total value of debit side of the income statement.

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In case, the value of total expenses exceeds the value of total incomes, a company will incur a loss which will again be reported in the income statement. It is important to note that the figure of net profit is available on the debit side of the income statement.

Meaning of Net Sales

Sales indicates the total revenue earned by the company before making any deductions on account of different types of business expenses. Total value of sales includes the value of cash sales and value of credit sales made by the company. Without calculating the value of sales, it is not possible to arrive at the value of net profit.

Accurate reporting of each sales transaction can help in estimating the correct value of net profit. In order to calculate net sales, it is important to adjust the value of total sales made by the company with the value of goods returned (also known as sales returns) by the customers.

Example of Net Profit Ratio

Let us assume that the value of net profit reported by ABC private limited in its income statement for the year 2010-2011 is $ 20,000. Company’s total sales for the year are $ 1, 00,000.

Assuming that there are no sales returns, we can easily calculate net profit ratio. Net profit ratio in this case is 20% ($ 20,000 (net profit)/$ 1, 00,000 (total sales)).