Keeping a close eye on your finances is vital as a small business owner but understanding exactly which numbers you need to have close sight of and the differences between them can take some time to master.
Often, it’s your profits that provide a good indication of your company’s health and will help inform the most important business decisions. However, the old saying that ‘cash is king’ is still very relevant today and gives lots of business owners more confidence to push ahead with their plans.
When it comes to analysing the profit in your business, there are two important metrics you need to be aware of, as well as understanding what makes them different. These are gross profit and net profit.
What is the difference between gross and net profit?
In simple terms, gross profit refers to your earnings before you deduct your direct costs – the additional costs incurred as a result of producing, selling or manufacturing your product or service.
Your net profit is your earnings after you subtract all of your indirect costs. These are sometimes referred to as fixed costs, so include things like rent, utilities and staff salaries.
Here we break down everything you need to know about gross profit and net profit.
What is gross profit?
Gross profit is an important measure for determining the financial performance of a business and reflects how much money your business makes when compared against the cost of producing and selling a product – also referred to as the cost of goods sold (COGS) for companies that sell physical products. Generally speaking, a high gross profit margin could indicate good financial health, but this is not always the case.
Important: Gross profit does not take into account additional costs such as rent, indirect staff costs, taxation and other indirect costs, which is why it’s vital you measure both gross and net profit.
How to calculate gross profit margin?
Calculating your gross profit will show you your top line earnings and is represented in pounds and pence. Your gross profit figure is calculated by subtracting COGS from revenue.
However, most businesses will use a gross profit margin to illustrate how well their company is doing. Gross profit margin is the percentage of revenue that exceeds the cost of goods sold and is calculated by taking the gross profit figure, dividing it by revenue and then multiplying by 100.
What is included in cost of goods sold (COGS)?
Cost of goods sold is the direct costs involved in producing a company’s goods.
The items that make up COGS typically include:
- Direct raw materials and inventory
- Direct labour costs
- Repair costs for equipment
- Items intended for resale
- Shipping costs
Tip: There is no true definition of a ‘good’ gross profit margin as it tends to vary by industry and the size of the business. There is a bit of a misconception that anything above 15% is a strong gross profit margin, but it can be very dangerous to work to figures like this as every business is different.
What is net profit?
Net profit is the measurement of your total costs subtracted from total revenue; in essence it is the amount of money that remains after all of your expenses have been paid.
Net profit can also be referred to as net income, net earnings or even the bottom line. It is often known as this due to its positioning at the bottom of a company’s income statement.
Net profit can, to some extent, give you a more accurate view of your company’s potential cash flow.
However, there are certain caveats to keep in mind. A company with a huge amount of machinery for example may have a lot of depreciation costs to consider. As this is a non-cash item, it would create a difference between cash flow and net profit that would be important to be aware of.
Another example would be a company that invests a lot of cash into assets, which again would create a difference between profit and cash flow.
What is an income statement?
An income statement is a financial document that outlines a company’s income and expenditure. It’s used alongside a balance sheet and cash flow statement to help businesses understand and establish the financial health of their company.
An income statement will cover the following information:
- Cost of goods sold (COGS)
- Gross profit
- Gains – Proceeds outside of the main activity of a business, e.g., sale of an investment
- Expenses; advertising, administrative, operational etc.
- Depreciation – An estimated expense used to reduce the carrying value of an asset, e.g., manufacturing equipment that will lose value over a period of time.
- Interest/finance costs
- Earnings before tax (EBT)
- Net Profit
How to calculate net profit margin?
Similar to gross profit, finding your net profit margin is quite a straightforward calculation. To work out your net profit, you must deduct the following from the company’s total revenue:
- All operating expenses – this could range from advertising or marketing costs to rent payments, pension contributions and utility costs
- Interest – interest payments on any existing debts, e.g. business loans
- Taxes – should consider corporation tax
- Preferred stock dividends (but not common stock dividends)
By dividing your net profit by your total revenue, you can calculate your net profit margin. This is used to indicate your profit after expenses as a percentage. This figure is often used as a measure of your company’s growth over a certain period and is a very useful metric to have.
Limitations of gross and net profit
While both gross and net profit are good profitability measures, they do have their limitations. For example, gross profit does not take into consideration all your business costs, and so isn’t always a true representation of your company’s profits.
Additionally, as mentioned earlier, it’s hard to benchmark gross profit as it can vary from industry to industry. For example, service-led businesses are likely to have higher margins than sectors like manufacturing or construction, that typically produce physical products and need to buy raw materials to do it.
Net profit is a more comprehensive measure of company profitability, but it can also have some limitations. Net profit can be impacted by one-off transactions, such as the sale of property, that could temporarily boost net income. The key point again is that there is a clear separation between profit and actual cash in the bank.
Frequently Asked Questions
Q: What could affect a company’s gross profit?
A: There are quite a few things that can impact on your gross profit figure, so it’s important that you closely monitor your COGS to identify any potential challenges.
An example of this would be changes to material costs – often external factors such as supply chain disruption, political unrest and even weather can increase the costs of raw materials, and this can then have a direct impact on your gross profit.
Q: Is net profit before or after-tax?
A: When producing an income statement, net profit can be shown as a figure before or after tax, however it is more common to deduct tax as part of your total expenses when calculating net profits.
Officially, there is no right or wrong way to do it, but most companies tend to do both. It’s also important that you make it clear whether your net profit figure is before or after tax.
Q: What is net profit after tax?
A: Net profit after tax is simply when taxes, such as Corporation Tax, VAT, and PAYE are included as part of the company’s total expenses when calculating net profit.
Q: How to calculate net profit after tax on turnover?
A: The calculation for net profit after tax on turnover would be exactly the same as on revenue. So, in this case you would take your total turnover and subtract all your expenses (including all taxes) to get your net profit after tax figure.
Net profit can often be one of the ways lenders determine how much money is appropriate to lend to a particular business, while also using your business credit, personal credit, and cash flow figures to determine your ability to pay the loan back. It’s important to make sure you understand your net profit to determine how easy or difficult it will be for you to manage repayments.
You can find out more about our business loans and qualifying criteria on our website or get in touch with our team of experts who are on hand to answer any of your questions.
*This article is intended to be a general guide only and should not be considered as official advice. Every business is different and has its own unique circumstances to consider. Business owners should always seek advice from qualified accountants.