Net Profit and Gross Profit Calculations: Assessing the Financial Health of Your Business
Becoming a business owner is a healthy career goal, and when you are ready to venture into the world of being your own boss, it is important to understand what net profit is and how to calculate it. After all, the main objective of a business is to generate profits. Understanding gross profit and net income/net profit calculations will help you assess the profitability of your business – that is, you will know the company’s ability to pay its debts, salaries, and bonuses.
This guide introduces you to three fundamental financial terms:
- Net profit
- Gross profit
We also show you how to calculate net income to gain insight into the overall financial health of your business.
Types of Profit
As a business owner, you should be aware that there are three major types of profit:
- Net profit
- Gross profit
- Operational profit
These terms are found in your company’s income statement, and they express profits related to the different categories of expenses.
1# What Is Net Profit?
Net profit = Gross profit (plus any other income) minus all business expenses.
In a business context, net profit describes the money you have left after deducting all the expenses from the total revenue. Some of the expenses you can expect include COGS (selling and administrative expenses), taxes, operating expenses, and interests.
Sometimes known as net earnings, net income is used by executives and entrepreneurs as the foundation for creating estimates and long-term business strategies. Net income is also known as ‘the bottom line’ since it is the last line of an income statement.
In other words, net income shows how efficiently your business is making money.
2# What Is Gross Profit?
Gross profit = Net sales minus the cost of goods sold, where Net sales = Gross sales minus returns, allowances, and discounts.
As you can see, gross profit depicts the difference between net sales and the cost of goods sold. The cost of goods sold (COGS) includes the amount spent on producing your products or services, including transportation costs (if any).
3# What Is Operating Profit?
Operating profit = Gross profit minus selling and administrative expenses.
Your business may have various administrative expenses, such as rent, payroll taxes, depreciation, utilities, salaries, insurance, office supplies, etc. Other expenses include the following:
- Shipping expenses
- Storage costs
- One-time payments
- Employee salaries
Operating profit shows your company’s profits from operations only, without considering income and expenses that aren’t directly related to the core operations of the company. It is the primary source of your company’s cash flow, and it depicts your earning power over a specific period of time.
Put in other words, it is used to determine your company’s financial stability.
If your operating profit is increasing consistently, it signifies a healthy financial growth. On the other hand, if it is dropping and is no longer sufficient to generate the cash your company needs to keep afloat, you may need to find other sources of funds.
If you don’t have any revenue, you don’t have a business. In accounting, revenue is the total income generated from the normal operations of a company over a specified period. Usually, it is brought from the sales of goods and services to customers.
Revenue is the gross or top-line income figure from which costs are subtracted to find net income.
How to Calculate Net Profit
Now that you have a basic understanding of the various financial terms, let's take a look at how to calculate net income. Like we mentioned above, net profit is the true measure of your company’s profitability. It is the figure you get after you subtract the total expenses from your total revenue. Here is the net profit formula:
Net profit = Total revenue minus total expenses.
Alternatively, you can use the following formula:
Net income = Revenue minus the cost of goods sold minus expenses.
As we pointed out earlier, revenue minus the cost of goods sold gives you the gross income/profit. That means the net income formula can also be expressed this way:
Net income = Gross income minus expenses
Your net profit can be positive or negative. If revenues exceed expenses, then you have a positive net profit. If expenses are more than your company’s revenues, then you have a negative net profit, also known as a net loss.
You can use the formula above to make net profit calculations for any given period, such as a month, quarter, or year.
Let’s say you want to find the net income of your online retail store for the first quarter of 2020. Here are some of the figures you may be working with:
- The cost of goods sold (COGS): $25,000
- Total revenue: $75,000
- Sales returns: $25,000
- Utilities: $3,500
- Salaries: $8,000
- Interests: $2,000
- Advertising: $5,000
You first need to find your gross income by subtracting COGS from your total revenue:
Gross income = Net sales minus COGS.
Therefore, gross income = ($75,000 - $25,000) minus $25,000 = $25,000.
Once you determine your gross income over that period, here’s how to get net income:
Net income = Gross profit minus expenses
Net income = $25,000 - $18,500 = $6,500
Your net income for the quarter is $6,500.
Your income statement would look something like this:
Income Statement For 01 Jan – 31 April 2020
Now, once you get that figure, ask yourself, “Is my business profitable? What can I do to increase my net profit?” Remember, this is the figure investors look at when you are looking for outside capital to boost your business.
They will also look at your net profit margin, which is calculated by deducting all the company expenses from the total revenue. Net profit margin, also known as profit margin or net profit margin ratio, is used to calculate the percentage of profit a business gains from its total revenue. In other words, net profit margin measures the amount of net profit a company obtains per dollar of revenue gained.
The formula goes like this:
Net profit margin = Net profit / Total revenue x 100
In the example above, the net profit margin = $6,500/$75,000 x 100 = 8.6%.
Why Net Profit Matters to Your Company
In a nutshell, net profit reflects your company’s profitability. Its figure shows how your business is performing, and with it come several benefits:
- Calculating your net profit helps you determine your business’ financial health. An ideal business setting is where you make more money than you spend. Tracking net profit over time gives you a clear picture of whether your profits are increasing or decreasing (monthly, quarterly, or annually).
- Your net profit figure helps you determine your paycheck. Using the net profit formula, you will be able to determine how much you have left after deducting the expenses. You can then decide to pay yourself using these funds or to pump the money back into the business.
- Calculating your net profit comes in handy when sourcing for funds. Investors, banks, and stakeholders will ask you for your net profit figure when you request a loan. It will help them to determine whether you will be able to pay your debts.
- Your net profit figure is required by the government to determine your tax liability and refund amount.
The Bottom Line
To improve your net profit, you should reduce direct costs, remove unprofitable products and services or discount them to move faster, reduce overhead expenses like supplies, rent, interest, and marketing expenses, and keep a close eye on your inventory.
Additionally, it is recommended that you always review your business and look for areas that need improvement.
If you are just starting out, investors and stakeholders may not necessarily base their decisions on your net income alone since your business is expected to take some time to start generating real profits. That said, you should always do your best to minimize costs whenever possible, keep track of your financial goals, and hit your profitability targets.
Speaking of keeping track of your finances, it is important to measure the performance of your employees to optimize your company’s profitability. No tool does this better than Traqq. It shows you detailed reports on each employee’s performance using online timesheets. You can then use them to identify underperforming employees and find ways to boost their productivity. Since the tool allows you to record employee working hours, you pay only for hours worked. What’s more, your payroll processing is automated. This means you only have to fill out employee payment details once and you can be guaranteed accurate payments each month.