As a small business owner, you should regularly look at your income statements to determine whether your company is making a healthy bottom line. Therefore, you need a clear understanding of your profits — or, more specifically, a full understanding of gross profits vs. net profits.
At the first glance, gross profits and net profits may seem similar, but the two provide very different information that can be used for a number of things. To help you understand the growth of your business, let's take a look at gross and net profits.
What is Gross Profit vs Net profit?
What is Gross Profit?
Gross profits are the amount your company made over a specific amount of time, less the cost of goods sold (COGS). The cost of goods sold includes items like raw materials, necessary labor, etc.
The formula for gross profit is:
Gross Profit = Net Sals - Cost Of Goods Sold |
Gross profit provides insight into how efficiently a company uses labor and supplies for manufacturing goods or offering services to clients. When the cost of goods sold (COGS) increases, the gross profit value decreases, so you have less budget to deal with your operating expenses. When the COGS value decreases, the profit increases, meaning you will have more money to spend on your business operations.
What is Net Profit?
Net profit is your company’s net sales minus COGS and all operating expenses — that is, administrative expenses, non-operating expenses like taxes or interest, and any expenses related to selling.
The formula for net profit is:
Net Profit = Gross Profit - Expenses |
Net profit is a crucial parameter that determines the financial health of your business. It shows whether the business can make more in profit than what it spends. Looking at a net profit can help you decide when and how to work towards expanding your business and when to reduce your expenses.
Additionally, net profits can be useful in providing a clearer view of your company's health and potential cash flow. And, your company's net profit can be used to attract investors.
When investors are considering which companies will be good investment choices, they will look at your net profit, because seeing solid gross profits means nothing if non-operational costs are destroying your bottom line. A positive net profit will send a positive signal to investors and increase your chances of attracting one.
Gross Profit vs Net Profit: The Key Difference
Understanding the difference between gross profit and net profit is important in several ways. It helps you find ways to minimize the costs of goods sold or raise your product prices. You need to compute correctly the values of gross and net profit to generate an income statement: a financial statement will reflect the health of your business. Inaccurate financial documents present an unrealistic picture of your business so it will affect their decision-making.
Here’s a quick review of the differences between gross vs net profit.
Basis | Gross Profit | Net Profit |
Definition | The leftover profit after deducting all the direct expenses from the manufacturing process. | The residual income that a company is left with after paying off all its expenses for a financial period. |
Objective | To estimate a company’s profitability. | To determine the company’s performance. |
Advantage | Controls excess costs | Shows a company’s performance in a year |
Reliability | It is difficult to make financial decisions using gross profit as it does not include expenses, taxes, and interest on loans. | This is a true profit that a company can use to make business decisions for its developments. |
Credit Balance | It shows the credit balance of the trading account | It shows the credit balance of the profit and loss account. |
Formula | Gross profit = Revenue - Cost of Goods Sold | Net Profit = Gross Profit - Expenses |
Gross profit is the amount of money you are left with after deducting the cost of goods sold from revenue, while net profit reflects the amount of money you are left with after having paid all your allowable business expenses. You need to calculate gross profit before arriving at net profit. Once you compute the correct values of your gross and net profit, you can generate an income statement. Gross profit and net profit are interdependent, so calculating the right values is important. This would keep the records maintained and provide insight into how effectivity of your business performing.