Net profit is an essential metric to consider when ascertaining your company’s financial health. It represents the profits left over when all the costs associated with selling your products and operating your business are subtracted. Tracking net profits will provide a clearer depiction of your profitability than tracking turnover.
Generating sales revenue is important. But when it comes to assessing the financial health of your company, it can be a misleading metric. After all, if your debts, operating expenditures, capital expenditures and other liabilities are high, they can consume a significant proportion of your revenues. They can even leave you with a deficit that forces you to rely on borrowing to cover the cost of doing business.
Net profit is calculated by stripping away expenses outside of your cost of goods sold (COGS).
There are two ways to do this, and you will need your income statement to perform the calculation.
- subtract the COGS, taxes payable, operating expenses, interest payable on debts and any other expenses from your income for the period
- divide the result by your total revenue from the period
- multiply this figure by 100 to express it as a percentage
A quicker formula to calculate net profit is to find your net income for the period on the bottom line of your income statement. Divide this figure by your total revenue and multiply the resulting figure by 100 to express it as a percentage.
Net profit example
Let’s flesh out the definition of net profit with a hypothetical example. Imagine you’re looking at your company’s income statement and it looks something like this:
- total revenue: £100,000
- operating costs: £30,000
- cost of goods sold: £15,000
- tax liability: £13,000
- net profits: £42,000
This would make your net profit margin .42 or 42% – this means your company earns 42p in profit for every £1 it makes. The further away you can get your net margin from the break-even point (the point at which your costs and revenues are equal), the higher your company’s profitability.
Net profit margin vs gross profit margin
For accurate financial reporting, it’s essential to differentiate between your net profit margins and your gross profit margins.
While net profit margin is the proportion of net profits to revenue, gross profit is calculated differently. Gross profit margin is the proportion of remaining revenue after the cost of goods sold has been deducted. This includes all expenses directly associated with bringing your product(s) to market. However, it does not include operational costs such as payroll, utilities or rent.
Gross profit margin is calculated by dividing gross profit by total revenue.
Frequently asked questions about net profit
Does HMRC charge tax on net profits or gross profits?
Whether you’re a business owner or a self-employed sole trader, you pay tax on your gross profits after all allowable expenses have been deducted. These are also known as adjusted profits. Tax liability is a component of net profit.
Why is it important to calculate your net profit margin?
Calculating your net profit margin is the key to ascertaining your company’s profitability. It shows you how much profit is generated from every £1 in sales revenue you make.
Is there anything I can do to improve net profits?
Improving net profits means improving revenues while reducing overhead costs. This can be a tricky balancing act. Making drastic cuts to operational spending may be detrimental to your brand from both a customer and employee viewpoint. Targeting areas of waste spending while pursuing low-cost means of improving revenue (such as upselling or customer referrals) will help you to achieve this balance.