Why is net profit margin important?

Sageworks
May 21, 2014
Read Time: min

There are numerous qualitative measures that can indicate expected financial performance when evaluating credit risk in new and existing business relationships. However, it’s important to consider the key metrics that accompany the 5 Cs of Credit.

In addition to the Debt Service Coverage Ratio, it is important to measure and monitor a firm’s Net Profit Margin.

What does this mean?

Net profit margin fundamentally shows the profitability of a company, and serves as a predictor of a firm’s likelihood to default on loans.  Sageworks’ Chairman, Brian Hamilton, explains: “Net profit margin is really a proxy for efficiency. Out of every dollar that you sell, how many cents in profit are you taking out?”

Why is it important?

The net profit margin is important to evaluate in lending decisions because it effectively shows the firm’s potential net worth based on earnings. This has a direct effect on capital reserves, which means the higher the profit margin, the more likely the business will be able to remain resilient in periods of unexpected losses.

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How to improve it?

According to Karen Berman and Joe Knight, coauthors of Financial Intelligence for Entrepreneurs, three possible fixes to a poor net profit margin are:

• Focus on reducing overhead expenses (though it may be a quick fix providing one-time savings),

• Increase sales volume so fixed costs are spread further, improving profitability, or

• Seek advice from customers as to how the company can optimize its offering, or find a new market (potentially boosting sales).

To learn more about which metrics mean the most in your credit analysis process, download the whitepaper Quantifying the 5 Cs: Credit Analysis Ratios that Matter.

About the Author

Sageworks

Raleigh, N.C.-based Sageworks, a leading provider of lending, credit risk, and portfolio risk software that enables banks and credit unions to efficiently grow and improve the borrower experience, was founded in 1998. Using its platform, Sageworks analyzed over 11.5 million loans, aggregated the corresponding loan data, and created the largest real-time database of private-company financial information in the United States. The company was acquired in 2018 and is now part of Abrigo.

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About Abrigo

Abrigo is a leading technology provider of compliance, credit risk, and lending solutions that community financial institutions use to manage risk and drive growth. Our software automates key processes — from anti-money laundering to fraud detection to lending solutions — empowering our customers by addressing their Enterprise Risk Management needs.

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