This is something you’ll need to know if you ever want to assess the financial health of your company. The ability to analyze different kinds of profit (the money your business brings in), will ensure you can make intelligent decisions about how to grow.
You can even use profit analysis to examine how your company has evolved over a period of months or years, by comparing existing numbers to past benchmarks. Here’s everything you need to know about gross vs net profit.
What is Gross Profit?
Profit is the money generated by a business. The gross profit of an organization looks at the amount of money you’ve made from sales over a specific period after you subtract the costs of manufacturing, marketing, and selling. Most companies will include all the goods sold over a financial period in a gross profit calculation while excluding the sales of fixed assets (such as equipment or buildings).
The formula for calculating gross profit is:
Total Revenue – Cost of Goods Sold= Gross Profit
For instance, if a company selling clothing made $2,000 in a month, but spend $500 on production, marketing, and sales, the gross profit for that business would be $1,500.
What can Companies Learn from Gross Profit?
Gross profit calculations are valuable because they help companies to determine how effectively they’re using labor, supplies, and processes for manufacturing goods and services. With a gross profit analysis, you can determine whether the “cost of goods sold”, such as manufacturing items and launching marketing campaigns, are draining too much of your final revenue.
Gross profit calculations can help businesses to determine what kind of steps they need to take, or what changes they need to make to increase sales revenue, and reduce operating expenses. Gross profit is also used as a fundamental part of defining “net profit
What is Net Profit?
Net profit is the amount of money earned by a business after all expenses for tax, interest, and operations are deducted, over a given period of time. In order to find this value, companies first need to determine their “gross profit”.
To calculate gross profit, companies use the formula:
Gross Profit – Expenses = Net Profit
Net profit considers all of the additional expenses that might detract from a company’s revenue that isn’t addressed by gross profit. If your expenses, such as taxes and interest rates lead you to have a negative “net profit”, this is referred to as a net loss.
What can Companies Learn from Net Profit?
Net profit is another important tool used to determine the financial health of a business. It’s commonly used by business leaders to evaluate whether a business is profitable and whether a business model is sustainable. A rundown of net profit can also help companies to market their organization to potential investors and shareholders.
In the business world, Net profit shows us there’s a key difference between profit and profitability. Profit is a simple number that equates to revenue, minus expenses. However, profitability is a relative number or percentage, which demonstrates how much money you can reasonably make.
If your net profit is positive, you know your business is sustainable and potentially valuable. If your net profit is negative, this shows you need to make changes to your operating procedures, tax requirements, or other expenses to keep your company afloat.
Most tax and government forms require companies to declare their net profit. Based on this number, financial institutions like banks can decide whether a loan should be issued. Lenders and investors also use the net profit to determine whether a company is capable of paying off its debts.
Gross Profit vs Net Profit: The Facts
All companies need to be able to track gross and net profit in their organizations to determine whether they can sustainably maintain their current business model. While net profit provides a more comprehensive view of an organization’s financial health, it’s impossible to calculate this number without first understanding gross profit. As a result, the two formulas often go hand in hand.
With an understanding of gross and net profit, companies can determine which expenses are detracting from their revenue, and where changes need to be implemented to improve profitability. Gross and net profit can also help companies to establish sales goals for long-term growth.
Once you know the correct values of your gross and net profit, you can also generate income statements, which are essential for companies at tax time.
Fortunately, there are tools available to assist companies with calculating net and gross profit automatically, using cloud-based software and data from invoices and cash statements.