What is net profit?
Net profit, also sometimes referred to as net income, is the money a company has left after deducting all expenses. These expenses can differentiate per company but usually include factors like operating costs, taxes, interest and depreciation. Essentially, a business’s net profit is its bottom line after it takes into account all the money it has spent over a determined period of time.
For most businesses, calculating net profit is an essential step in business accounting, but it also provides helpful insights into its overall success. For example, a company’s goal might be to increase profit month-over-month, and in order to measure the progress towards that goal, they would need to look at its monthly net profit to see if it has increased or not.
What’s the difference between net profit and gross profit?
These two terms often confuse new business owners, but net profit and gross profit refer to two different things. As we already covered, net profit is a business’s income after deducting all overhead costs. By contrast, gross profit refers to the profit made on products or services after the company deducts the cost of producing or providing these goods.
In other words, gross profit helps a business understand the cost efficiency of producing its products or services before taking other business costs into consideration, while net profit looks at the entire cost of running a business.
An example would be a small eCommerce company that sells t-shirts on their online eCommerce website. To calculate the gross profit, the company would need to figure out its total sales (sales) and deduct the cost of goods sold (COGS). The equation would look like this:
Gross profit = Sales - COGS
So, if the company makes $1,000 in one month from its t-shirt sales, and the cost of producing the t-shirts was $300, the gross profit is $700. This equation can show a company how efficient its manufacturing process is. Unlike net profit, however, it doesn’t take any other costs into consideration, such as the cost of creating a website and running it, marketing or paying taxes on the sales.
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Why is net profit important?
There are a number of reasons why calculating the net profit is important for businesses. Aside from showing how much a business really earned, and its retained earnings, over a set period of time, this metric has a number of other important implications.
1. Shows a business’s profitability
It’s important to differentiate between profit and profitability. A business’s profit is simply its total revenue minus expenses, but profitability shows how well the business is performing overall and can be an important factor for businesses that want to attract new investors.
2. Reveals the overall financial health of a business
A company’s net profit demonstrates whether the business is profitable or not. If the overall costs of running a business outweigh the total revenue, then it’s time to reconsider certain processes within a business to become more efficient.
3. Fulfills requirements of certain tax or loan forms
When it comes for businesses to file taxes, the government wants companies to declare their net profit. Similarly, for businesses who want to apply for a loan, it’s common for banks to request their net profit to see their ability to pay back debt.
4. Allows businesses make better decisions
Whether a business is profitable or not will help them make key decisions moving forward. If a business is losing money, it needs a new business plan. On the other hand, if the net profit is higher than expected, a company should consider how to reinvest that profit with the intention of expanding.
5. Helps businesses discover trends
If a company is regularly looking at its net profit either month-over-month or year-over-year, it will be able to discover trends associated with its business. Whether that means increased sales one month due to a holiday, or seeing how a business’s net profit has increased each year.
6. It’s essential to calculate a business owner’s salary
After deducting expenses, a small business owner can see how much they will earn based on the net profit. This is especially important to small businesses, which might only be made up of one person or a couple of employees.
Keep in mind that the entire net profit shouldn’t necessarily go to the business owner’s pocket if they also want to invest in expanding their business.
How Is Net Profit Calculated?
There’s a simple equation businesses use in order to calculate their net profit. Essentially, you want to deduct the total cost of your expenses from your overall revenue. It would look like this:
Net profit = Total Revenue - Total Expenses
While this equation might look straightforward, there are many costs that can go into total expenses. Here are a few common expenses businesses might need to factor into their total expenses:
Cost of goods sold
Rent and utilities
Employee salaries, commissions, or bonuses
Depreciation of a business
Banking or accounting costs
Repairs or maintenance
Losses on sales
To gain a better understanding of how a business might calculate its net profit over a period of one year, let’s take a look at an example. Say that same t-shirt company from above earns $40,000 a year in total revenue from its sales. The breakdown of calculating its net profit would look something like this:
Total revenue: $40,000
Cost of goods sold: $5,000
Gross profit: $35,000
Total operational expenses: $10,000
Net profit: $20,000
While this is quite a basic example, it still does a good job of illustrating the differences between total revenue, gross profit and net profit. Sometimes new small businesses will get excited by the prospect of generating a certain amount of revenue each year, but what they don’t take into account is all the other expenses that are necessary to running a business. Once all these factors are deducted, the net profit will reflect a completely different story.