Net profit ratio (NP ratio) is a popular profitability ratio that shows relationship between net profit after tax and net sales. It is computed by dividing the net profit (after tax) by net sales.

Formula:

net-profit-ratio-formula

For the purpose of this ratio, net profit is equal to gross profit minus operating expenses and income tax.  All non-operating revenues and expenses are not taken into account because the purpose of this ratio is to evaluate the profitability of the business from its primary operations. Examples of non-operating revenues include interest on investments and income from sale of fixed assets. Examples of non-operating expenses include interest on loan and loss on sale of assets.

The relationship between net profit and net sales may also be expressed in percentage form. When it is shown in percentage form, it is known as net profit margin. The formula of net profit margin is written as follows:

net-profit-margin-formula

Example:

Sales $ 210,000
Returns inwards 10,000
Gross profit 80,000
Administrative expenses 15,000
Selling expenses 15,000
Interest on investment 10,000
Loss on account of fire 6,000
Income tax 5,000

Net profit ratio would be computed as follows:

net-profit-ratio-formula

= ($45,000* / 200,000**)

= 0.225 or 22.5%

*Computation of net operating profit after tax:

Gross profit 80,000
Less operating expenses:
  Administrative expenses 15,000
  Selling expenses 15,000 30,000
——- ——-
 Net operating profit before tax 50,000
Less income tax 5,000
——-
Net operating profit after tax 45,000
 ——-

Note: Interest on investment and loss on account of fire has been ignored because interest on investment is a non-operating income and loss on account of fire is a non-operating loss.

** Computation of net sales:

210,000 – 10,000 = 200,000

Significance and Interpretation:

Net profit (NP) ratio is a useful tool to measure the overall profitability of the business. A high ratio indicates the efficient management of the affairs of business.

There is no norm to interpret this ratio. To see whether the business is constantly improving its profitability or not, the analyst should compare the ratio with the previous years’ ratio, the industry’s average and the budgeted net profit ratio.

The use of net profit ratio in conjunction with the assets turnover ratio helps in ascertaining how profitably the assets have been used during the period.