A Guide to Net Profit: Definition, Formula and Example Calculation

Profit is the money that a business brings in. Comparing current profits to profits from previous accounting periods helps you understand the growth of the business. To create accurate financial statements and monitor your business’s financial health, you should understand the two types of profits: gross profit and net profit.

Gross profit is the profit a business makes after subtracting all the costs that are related to manufacturing and selling its products or services. You can calculate gross profit by deducting the cost of goods sold (COGS) from your total sales.

While calculating the total sales, include all goods sold over a financial period, but exclude sales of fixed assets such as buildings or equipment.

Net Profit and Gross Profit | Formulas, Margin Calculations and How to Interpret Figures Explained

Why is net profit important?

Net profit is important because of what it represents. It gives business owners a true sense of how their company is faring because it considers both income and all business expenses. Its common for companies to write up a new income statement each financial quarter so that shareholders and other interested parties can look at the status of the business. With the money left over after a business pays for its expenses, it can then distribute money to owners and shareholders.

When a business is able to pay shareholders, it typically means that operations are strong and that the company has a solid foundation with which itll continue to grow and realize increased profits over time. This leads to higher stock prices and a larger valuation of the company, so an owner is more likely to find success should they pitch to a group of investors for capital to grow the business or need to secure a loan to expand operations.

A successful company will continuously look at its net profit to determine how it can improve. It does this by finding ways to decrease expenses, like by moving to a more cost-effective office space or outsourcing some work, or exploring opportunities to increase revenue, like through a product line expansion or inventory sale.

Here are some other reasons why net profit is important:

Although net profit is important, its also important that you not use this total and compare it to the net profit of another business. Net profit can vary widely, even between companies in the same industry. Net profit also doesnt provide any insight into how much cash the company generates in a given period of time. For that, you can use a cash flow statement.

What is net profit?

You may also refer to net profit as the bottom line or net income, and its the amount of money a business has after it accounts for all expenses. These expenses may include payroll, manufacturing costs, monthly rent for office space, taxes, employee benefits and more. Net profit also accounts for expenses without a cash basis, like the depreciation of an assets value, and interest, cost of goods sold and amortization. Net profit appears on the last line of the companys income statement to showcase the total income of the organization.

What is net profit margin?

Net profit margin is a ratio thats expressed as a percentage. It showcases the companys profit as a percentage of total revenue. Net profit margin measures the effectiveness of a companys operations because it shows how often and in which amounts a business is able to turn over a profit.

For example, if a company has a net profit margin of 30%, it means that it retains $0.30 for every $1 in revenue. It also shows that the company loses out on $0.70 for every $1 in revenue. Its common for owners and strategists to explore ways to increase net profit margin.

The formula for net profit margin as a percentage is:

Net Profit Margin = Net Profit / Total Revenue x 100

When you express net profit margin as a percentage, it makes it easier and more worthwhile to compare the profitability of two companies, which differs from net profit. By keeping track of net profit margin over a certain number of years, you can identify any trends. For example, you may see that operating costs are steadily increasing each month, which will contribute to a smaller net profit margin over time. Stakeholders can then identify where the issue is or what they can do to combat the downward movement.

Just like with net profit, investors pay attention to the net profit margin for a business. They are looking for net profit margins that continue to increase between months or fiscal years. This also affects the companys share price, as a business can prove its success through their earnings releases and annual reports.

The downside of net profit margin is that its not as reliable if you have a temporary expense or income figure that skews the data. For example, if you make a major sale of your manufacturing equipment, you may notice a false sense of high profits. However, it would only be for a short period of time. Its important to consider net profit margin along with several other figures to determine the financial health of a business.

What’s the formula for net profit?

Because net profit considers both total revenue and total expenses, the net profit formula is:

Total Sales Revenue – Total Expenses = Net Profit

To calculate net profit for your business so you can understand its financial status better, follow these steps:

How does net profit differ from gross profit?

The main difference between net profit and gross profit is what you subtract from the companys total revenue. While youd subtract total expenses from total revenue to reveal a companys net profit, youd subtract the cost of goods sold (COGS) from the total revenue to establish the companys gross profit. COGS is the cost you incur to product the goods you sell as a company, which may include materials, labor and distribution costs.

Gross profit lets a business know how successful it is before including any overhead costs. It connects the COGS figure with the companys financial success because business owners can clearly see where they may be able to change their product line or manufacturing process, as examples, to realize a healthier bottom line and greater profitability. Gross profit can be helpful because the cost of goods sold is the part of the business that is most adjustable, whereas operating and overhead costs are more likely to remain the same because the business owner has less control over them.

Example of a net profit calculation

Use this example of a net profit calculation to better understand how net profit works:

Company ABC sells paper products like notepads, planners and greeting cards. They also have a large following of individuals who like paper planners, so the company has become known for its courses where experts teach others how to start a planner and organize it for their needs. Lastly, there is another part of the business that is exclusively for branded stationary. To calculate the companys total revenue, you must add up the revenue from all income streams, which may be $150,000, $50,000 and $75,000, respectively. Company ABCs total revenue would be $275,000.

Company ABC would then need to calculate its total expenses, which could include $75,000 for employee salaries, $35,000 for equipment rental, $10,000 for office space rental, $5,000 for office equipment and $12,000 in taxes for a total of $137,000 in expenses.

If you use the net profit formula to subtract total expenses from total revenue, net profit is $138,000. This represents the amount of money left over after the business pays for everything it needs to. This means that the owner may earn a salary, the business may pay its shareholders or the net profit will go into a business savings account or get reinvested back into the business.

Also, you can now calculate net profit margin. Following the formula, net profit margin is calculated by: $138,000 (net profit) / $275,000 (total revenue) = 0.50 x 100 (to express net profit margin as a percentage) = 50%. This means that for every dollar that Company ABC makes, it retains $0.50 for itself.

FAQ

How net profit is calculated?

Net profit is gross profit minus operating expenses and taxes. You can also think of it as total income minus all expenses.

What is net profit and gross?

Gross profit shows how much money your business makes after meeting some costs. Net profit shows how much you make after meeting all costs. A business’s gross profit is the money it has left after paying for the goods and services it sold. Its net profit is the money left after paying absolutely all expenses and taxes.

What is net profit known as?

Synonymous with net income, net profit is a company’s total earnings after subtracting all expenses. Expenses subtracted include the costs of normal business operation as well as depreciation and taxes. Net profit is commonly referred to as a company’s “bottom line” and is a true indicator of a company’s profitability.

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