# Net Profit Ratio

It is the quotient that expresses the relationship between net profit and sales. It is expressed as;

Net profit ratio=

Definition of;

Operating profit-it is the excess of gross profit over operating expenses

Operating expenses-it the expenses that are incurred or paid by the business so as to be supplied with other services to ensure smooth running of the business. Those expenses are categorized in to administration, and selling and distribution expenses

Example

The following trial balance belongs to Wellness co ltd as at 30th/06/2015

Closing inventory      \$24,000

Required

i). Determine the operating profit as at 30th/06/2015

ii). Compute the Net profit ratio

iii). Interpret the results

Solution

Interpretation

For every sales of \$1 the organization generates net profit of \$0.211

NB-You can see that other expenses such as loan interest has not been factored in for it is a financing expense

-Also, interim dividend for both preference shareholders and ordinary shareholders were not considered in determination of net profit for they are both appropriations and not operating expenses. In fact, they do not contribute to the operational efficiency of the organization.

## Applicability of Net profit ratio in Decision Making by Management

Net profit ratio has a role to play in management decision-making spheres

Denominator factor

One; sales being the denominator, in the expression of Operating Profit/Net Sales,the management need to interrogate factors such as pricing policy to ensure that the organization’s products remain competitive in the market for failure to do this will adversely affect the net profit level in an adverse manner.

On the same breath, the sales element is usually net of any returns inwards. Return inwards results to decline in the level of the sales value which adversely affect the gross profit. Therefore, the management need to ensure that no anomalies resulting to return of sales already made. This can be achieved by;

1. Clean delivery policy; Ensuring during delivery of the sold goods, the supply is as per the set standards of the organization and as per the customer’s preference or Terms of Reference (TOR).
2. Sales promotion policy; Ensure the products of the organization are ever in the market domain for the assurance of marketability and increased sales levels
3. Pricing policy; ensure the pricing policy does not scare customers from the product for this can lead to loss of market share

Numerator factor

In the expression Operating Profit/Net Sales,operating profit is the numerator and it is composed of gross profit less operating expenses.

Operating expenses are all expenses incurred or paid by the organization to ensure smooth day to day operations of the business as supposedly.

Under these aspects, the management can apply the formula to

1. Establish operating expense policy where by the management need to put Key Performance Indicators (KPI) to guide on the extent to which operating expenses should rise or fall. In other words, the indicators can act as thresholds to mark the acceptable levels of operating expenses. This will aid in ensuring that such expenses do not exceed the acceptable points. As a result, net profits are predictable.

About the Author - Dr Geoffrey Mbuva(PhD-Finance) is a lecturer of Finance and Accountancy at Kenyatta University, Kenya. He is an enthusiast of teaching and making accounting & research tutorials for his readers.