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Have you ever wondered about the difference between gross and net income? The two are quite different, but both are important to understand when you’re running a business. Entrepreneurs, start-ups, small businesses and large corporations alike all need to understand the difference, and why each figure matters.
Not only is it important when it comes to accounting and tax time, it’s also important for business planning and managing cash flow. Once you’re familiar with all the necessary financial terms and how they affect your business, you’ll find that things run a lot smoother.
So, let’s take a look at the two income types, how they’re different. And how they affect your business.
The difference between gross and net income
In very simple terms, your gross income is the total amount of income you generate. The net income is your actual profit after business expenses. Of course, it goes a little deeper than that, but this is the major difference between the two.
So, while it’s great to look at your total earnings and feel like you’re generating enough income, you also need to take into account all of your expenses. For example, if you sell a product for $100, but the costs associated with the products are $90, you’re only making $10.
Another way to look at that scenario, is you’re making 10% on each sale. We’ll touch on the importance of percentages a little later on. For now, let’s look in more detail at the two income types.
What is gross income?
Gross income is your total income generated from sales. Whether you’re a sole trader, a small business or a large enterprise, you should be able to see the total amount of income you generate. Depending on how you look at it, gross income is probably the least important figure of the two. While all businesses should be trying to improve their gross income, it’s probably more important to improve their net income.
It’s important to note that your gross income is calculated before expenses, but also before taxes. This is because you’re only liable to pay tax on your net income (or taxable income). So, again, while gross income figures look great, you not only have to consider that your expenses eat away at your income, but so do taxes.
What is net income?
Net income is essentially what’s left over after you factor in all of your operating expenses. Obviously, operating expenses look very different depending on the type of business you’re running. For example, let’s consider you’re an entrepreneur trying to develop an app. You might be doing this from home, so there aren’t really many overheads. However, you’ve got the costs of hiring developers, designers, doing market research, website development, and possibly some costs associated with technology.
If you run a restaurant, you have lots of regular expenses, such as purchasing all of the food and ingredients you sell. You’ve got wages, superannuation, insurance, rent and a whole host of other expenses to keep your business going. Regardless of the business type, your net profit is the gross income minus any expenses.
How to calculate gross profit
Calculating your gross profit is pretty easy, and you don’t need any complex financial analysis to make it happen. It’s basically the total figure of all your sales throughout the year. If you’re using an invoicing system, accounting program or something similar, it will be easy to identify this figure.
If not, you’ll need to look back at all the income you’ve generated, and this might mean looking back through bank statements or checking your manual records. Even if your business is small, it pays to have some kind of accounting system in place because it makes things so much easier at tax time. For more information, check out our article on small business finance.
How to calculate net income
Calculating your net income is a little more complex, but again, with a good accounting system, it shouldn’t be too hard. Basically, you just need to add up all of your expenses for the year. So, that means everything you’ve paid out, and it can include any of the following:
- Salary and wages
- Office equipment
- Vehicle expenses
- Purchase of stock
- Operating costs (phone, internet etc)
- Marketing expenses
This list is not exhaustive by any means, but it illustrates that you need to factor in every cent that you spend on operating your business.
Once you’ve added up your total expenses, simply deduct them from your gross income, and you’re left with the net profit.
Gross Income – Expenses = Net Income
Why are gross and net income figures important?
There are several reasons why these figures are important. Let’s check out a few of the main reasons that people use gross vs net income when running their business.
When it comes time to lodge your tax return, whether it’s a business or personal one, you need to know both figures. If you don’t, you could end up paying more tax than you need to. Preparing a tax return is complicated, but if we look at the simple and basic principles, it becomes clear that gross and net income matters.
You’ll provide the ATO with your gross income figures, minus your deducted expenses. This is your net income, but it’s also your taxable income. So, you don’t pay tax on your gross profit, rather your net income. If you’re not calculating expenses correctly, you might pay more tax than you should.
2. Cash flow
Many businesses use a balance sheet to manage cash flow. Cash flow is important, because you need to know that you’ve got enough income to keep up with your operating expenses. Again, this is why it’s so important to have an accounting system in place that you can understand.
Remember, another thing you have to consider is GST. This tax needs to be paid quarterly. You also need to pay things like superannuation and PAYG tax throughout the year. Inputting all of your income and all of your expenses correctly into your accounting software ensures you’ve always got a snapshot of your cash flow. It tells you how much you need on hand to pay all of these outgoings.
3. Business planning
Finally, gross income vs net income is so important for business planning. Many people think the key to making more money is to increase your gross income. While that’s true to an extent, it’s your net income that really represents business growth. You might increase your gross income, but if your expenses increase too, your net income might remain the same. That means you’ve got the same amount in your pocket. So, always focus on ways to increase your net profit, not just your gross income.