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Profitis the money thata 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.
What is gross profit?
Gross profit is the profit a business makes after subtracting all the costs that are related to manufacturing and sellingitsproducts 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, butexcludesales of fixed assets such asbuildings or equipment.
What does gross profit tell you?
Gross profit is a measure ofhow efficientlyan establishment useslabor and supplies for manufacturing goods or offering services to clients. It isan important figure when checking the profitability and financial performance of a business.
Gross profit helps youunderstand the costs needed to generate revenue. When the value of the cost of goods sold (COGS) increases, the gross profit value decreases, so you have less money to deal withyour operating expenses.When the COGS value decreases,there will be an increase in profit, meaning you will havemore money to spend for your business operations.
What is net profit?
Net profitis the amount of money your business earns after deducting all operating, interest, and taxexpenses over a given period of time.To arrive at this value, you need to know a company’s gross profit.If the value of net profit is negative, then it is called net loss.
What does net profit tell you?
Net profitisanotherimportant parameter that determines the financial health of your business. Itshows whether the business can make more than what it spends.You can use your net profittohelp you decide when and how to work towards expanding your business and when to reduce your expenses.
For a business owner, it is important to know the difference between profit and profitability. Profit is an absolute number which is equal to revenue minus expenses. Profitability, on the other hand, is a relative number (a percentage) which is equal to the ratio between profit and revenue.
Profitability is a measure of efficiency and it is useful in determining the success or failure of a business.
Net profit tells you about the profitability of your business. Knowing about the same has several advantagesbeneficialforthe business.
Most government forms and tax forms require you to declare your net profit.Based on your net profit,thefinancial institutions, like banks, decide whether to issuealoan or not.This stands true because net profit is a common field found on business tax forms.Furthermore, lenders and investors look at your company’s net profit to check if youown the capability to pay your future debts.
Importance of knowing the difference between gross profit and net profit
Net profit tells your creditors more about your business health and available cash than gross profit does. When investors want to invest in your company,theywill refer to the net profit of your business to checkwhether it is worthinvestingtheir money.
Understanding gross profit trends, on the other hand, can help you find ways to minimize the cost of goods sold or raiseyour product prices. And if your gross profit is less than your net profit, then youknow that you need to find a way to cut down your expenses.
You need to know the correct values of gross and net profit to generatean income statement: a financial statement that reflects the health of your business.Not knowing the difference between the two mayresult in inaccurate financial documents thatpresent anunrealistic picture of your business. Thethree main financial documents aid the management in making important business decisions, so if they show incorrect profit information, it will affect their decision-making.
How to calculate gross and net profit?
You can calculate both gross and net profit usingyourincome statement. An income statement shows your company’s total revenue and cost of goods sold, followed by the operating expenses, interest and taxes.
In the following example, we are looking at an annual income statementfor Excel Technologies for the year 2018. The company records a total revenue of $200,000.
Gross profit = Total revenue – Cost of goods sold
= $200,000 – $50,000 = $150,000
Successful businessesshow a positive valuefor gross profit. The money accounted as gross profitpays forexpenses like overhead costs and income tax.
To calculate the net profit, you have to addupall the operating expenses first. Then you addthetotal operating expenses, includinginterest and taxes, and deduct it fromthegross profit. In the above example, the total operating expensesincluding taxes and interestare $110,000.
Net profit = Gross profit – Expenses
= $150,000 – $110,000 = $40,000
When the value of net profit is positive, then the business owners canpaythemselves and their partners after paying off their expenses.
When the value of net profit is negative, then it is called a net loss.This usually occurs inthecase of new businesses that do not earn enough to pay off their overhead costs or income taxes. In such cases, keep track ofeach type of expenses so that you canfind areas tocut downwithout sacrificing the company’s operations and efficiency. Toavoid facing a net loss after tax payments, the company should track expenses by developing a budget that includes potential tax payments per year. This will help them develop salesgoals that meet their financial needs.
Gross profit vs net profit – A comparison chart
Here’s a quick review of the differences between gross and net profit:
Your takeaway
Net profit reflects the amount of money you are left with after having paid all your allowable business expenses, while gross profit is the amount of money you are left with after deducting the cost of goods sold from revenue.You need to calculate gross profit to arrive at net profit.Once you knowthe correct values ofyourgross and net profit, you can generatean income statement.Gross profit and net profit are inter-dependent, so calculating the right values is important. This would keep the records maintained and help in determining if your business is performing efficiently.
Using Zoho Books, you can easily generate real-time business overview reports like P&L statements to evaluate the values of gross and net profit. Try out our cloud accounting softwarefor free to know how it will help you generate and maintain your records while performing business activities efficiently.
