What is Net Profit?
Net profit is the total amount of money a business retains after deducting all expenses, including operating costs, taxes, interest, and depreciation, from its total revenue. It is the definitive measure of profitability, often referred to as the “bottom line” because it appears at the end of the income statement.
A positive net profit indicates that a business is making money, while a negative net profit (net loss) means it is spending more than it earns. Because of this, net profit is the final measure of a company’s financial success, impacting everything from investor confidence to business growth.
Synonyms
- Net income
- Net earnings
- Bottom line
Understanding Net Profit
Net profit on the income statement
In financial reporting, net profit is prominently featured in the income statement. Also known as the profit and loss statement (or P&L for short), this is the document that outlines a company’s revenues, expenses, and profits or losses during a particular period, which culminate in the net profit figure.
In order from start to finish, the line items that bridge the gap from revenue to net profit are:
- Total revenue: This represents the total income generated from core business activitie, less any sales returns and allowances.
- Cost of goods sold (COGS): These are the direct costs attributable to the production of the goods sold by the company, including expenses like raw materials and direct labor.
- Gross profit: Calculated as net sales revenue minus COGS, gross profit indicates the efficiency of production and the core profitability of the company’s products or services.
- Operating expenses (OpEx): These are the costs required to run the company’s regular operations. They include selling (costs related to marketing and distribution, like advertising and sales commissions), general and administrative (G&A) (overhead costs not directly tied to production, like salaries, rent, and utilities), depreciation, and amortization.
- Operating income (operating profit or EBIT): Derived by subtracting operating expenses from gross profit, this figure reflects the profit generated from regular business operations before accounting for interest and taxes.
- Other income and expenses: This category includes revenues and costs not related to primary business activities, such as interest income, gains or losses from investments, and other non-operational items.
- Earnings before taxes (EBT): Profit before deducting taxes, calculated by adding your “other income” and subtracting “other expenses” from operating income.
- Income tax expense: The estimated amount of taxes owed based on the EBT.
From there, you get net profit, the final figure in the equation, by subtracting your income tax expense from EBT. This represents your company’s total earnings after all expenses, taxes, and costs have been deducted from total revenue.
Beyond the income statement
Aside from income statements, the net profit figure is used on your other two key financial statements as well.
On the balance sheet, it contributes to retained earnings within the equity section, representing the cumulative profits that have been reinvested in the business rather than distributed as dividends. This number speaks to the long-term financial health of your company and its ability to reinvest and continue growing.
On the cash flow statement, it serves as the starting point for calculating cash flows from operating activities, highlighting the cash generated or consumed by your company’s core operations. This demonstrates your company’s ability to turn a profit solely from core business activities, without relying on external sources of financing.
Importance of Net Profit for Businesses
This metric is one of the most important — it shows you (and anyone who’s considering investing in your company) how much money is really coming into the business. This has far-reaching implications for just about every area of your business, from a financial standpoint.
Serving as a key performance indicator (KPI)
While top-line metrics like sales revenue can validate the demand for your product and product-market fit, they don’t tell you anything about capital efficiency or long-term viability. Net profit does. That’s why business leaders use net profit data to determine cost-cutting strategies, pricing adjustments, and growth investments.
Conducting financial health assessments
A positive net profit indicates your company is profitable, while a negative net profit (net loss) suggests you’re facing financial difficulties. Using this as your starting point, you can start looking into other metrics like gross profit margin and operating expenses to get a better understanding of your financial health and cost efficiency.
Attracting lenders, investors, and buyers
Profitable businesses are able to reinvest the excess into revenue growth, expansion, and product innovation, which allows them to carve out their niche in their market over time and develop a competitive advantage. When you show investors, lenders, and buyers these things, what they see is a way to get their money back.
It isnt the be-all-end-all — for instance, SaaS investors use the Rule of 40 to account for the fact that young startups with great products might not have achieved profitability yet. But, in general, it’s easier for profitable companies to secure funding (at a higher valuation).
While valuation multiples vary across industries, reflecting different growth prospects, risk profiles, and market conditions, a company with better margins and a sustainable profit stream will fetch a higher valuation than its unprofitable counterpart.
Determining your tax liability
Since corporate taxes are based on net profit, you need to know what it is to calculate your tax bill. Managing your net profit effectively through investments and expenses can also help you optimize your tax obligations.
How to Calculate Net Profit
Now, let’s take a look at the step-by-step process for calculating this figure, and look at some real-world examples of how to apply it.
Net profit formula
The formula for calculating net profit is quite simple:
Where:
- Total revenue refers to all income generated from sales, services, and other sources.
- Total expenses include operational costs, wages, rent, utilities, raw materials, taxes, interest, depreciation, and amortization.
From there, the resulting number can be compared to previous periods, industry benchmarks, and projected goals to assess financial performance.
Determining net profit step by step
If you don’t have your total revenue and expense figures available, start by determining your total revenue (from core business activities) for the period. Then, work down the lines of the income statement to determine each individual number for that same period. At the end, you’ll arrive at your final number — your net profit.
Here’s a step-by-step sample of what that might look like:
Calculate total revenue
Total revenues on the income statement comprise the income generated from all your core business activities, less sales returns and allowances.
Example: A company sells 1,000 units of its product at $50 each, with no sales returns or allowances.
Total Revenue = 1,000 units × $50/unit = $50,000
Determine cost of goods sold (COGS)
COGS includes all direct costs related to the production of goods sold.
Example: Direct materials cost $20,000, and direct labor costs $5,000.
COGS=$20,000+$5,000=$25,000
Calculate gross profit
Your gross profit is your total revenue minus your COGS.
Gross Profit = $50,000 − $25,000 = $25,000
Subtract your operating expenses
OpEx is the sum of the costs required to run your business that aren’t directly tied to production.
Example: Rent is $3,000, utilities are $1,000, and salaries are $7,000.
Total Operating Expenses = $3,000 + $1,000 + $7,000 = $11,000
Calculate your operating income
Subtract OpEx from your gross profit to get your operating income.
Operating Income = $25,000 − $11,000 = $14,000
Subtract your other expenses
Other expenses could include interest payments or any other non-operating expenses.
Example: Interest expense is $500, and miscellaneous expenses total $1,000.
Total Other Expenses = $500 + $1,000 = $1,500
Determine your tax liability
Your tax liability is the amount of taxes you owe on your business profits. There isn’t an exact way to calculate it from your income statement — there are dozens of technicalities. For the sake of simplicity, we’ll use a tax rate of 25% and assume no special circumstances or deductions.
Tax Liability = ($14,000 − $1,500) × 0.25 = $3,125
Calculate net profit
Net profit is your operating income minus interest, taxes, and other expenses.
Net Profit = $14,000 − $1,500 – $3125 = $9,375
Summary table:
Summary table
How changes in revenue or expenses impact net profit
Net profit is highly sensitive to changes in revenue and expenses (in ways that might surprise you). Let’s explore a few different scenarios in an example table below:
As you can see from Example #1, just a 20% increase in revenue (from $100,000 to $120,000) results in a 100% increase in net profit. And if you look at Example #3, an expense increase by just 12.5% caused profits to be cut in half.
However, when we look at Example #2, we can see that increasing revenue and expenses each by 20%, still resulted in a 20% higher net profit.
The important takeaway from this is that while increasing revenue generally enhances net profit, it’s crucial to manage expenses effectively to ensure that profit margins are maintained or improved. Conversely, reducing expenses can bolster net profit, even if revenue remains constant or decreases slightly.
Net Profit vs. Gross Profit
Gross profit (total revenue minus COGS) reflects the efficiency of a company’s core operations in generating profit from its products or services. A higher gross profit indicates you’re efficient at turning raw materials and labor into finished products.
Regularly reviewing gross profit allows you to identify trends in direct costs associated with production. An unexpected decrease in gross profit could indicate rising material costs, labor inefficiencies, or other issues affecting COGS.
This metric also helps you isolate the effects your pricing strategy has on your profit margins. It reflects the difference between your selling prices and COGS, so it makes it easy to see how your current pricing (and changes to it) affect profit.
Since net profit factors in every expense the business incurs, gross profit is a better metric for evaluating these areas than net profit. It would be impossible to isolate production costs or sale prices from all other expenses to determine what’s the most and least effective.
If you need to evaluate the performance of your business as a whole, though, net profit is the metric you’ll use.
Key Financial Metrics Related to Net Profit
Other than net profit, there are a few profit-related metrics that will give you the complete picture of how your business is doing.
Net profit margin
Net profit margin is the ratio of net profit to total revenue, expressed as a percentage. A higher net profit margin indicates a business is more efficient at controlling costs and generating profits from sales.
In the hypothetical example we used in our step-by-step guide to calculating net profit, that would be:
Return on assets (ROA)
ROA is a measure of how well a company is using its assets to generate profit. It takes into account the total value of a company’s assets and compares it to its net income.
Two companies might report the same net profit, but the one with a higher ROA is utilizing its assets more efficiently to achieve that profit. This efficiency can be a critical factor in industries like B2B manufacturing, healthcare, and telecom, where asset utilization is key to competitive advantage.
In the example above, if the company’s total assets were $200,000, then its ROA would be:
A return on assets of around 10% is considered good. Above 10% is excellent, while below 5% is generally seen as unfavorable.
Return on equity (ROE)
ROE measures profitability in relation to shareholders’ equity. It indicates how effectively management is using equity financing to generate net income — that is, how much profit you make for every dollar shareholders invest, and what kind of returns they can expect.
It’s particularly valuable in the financial services, technology, and consumer goods sectors, which tend to more rely heavily on equity financing.
In the example above, if the company’s shareholders’ equity was $150,000, then its ROE would be:
Return on equity ratios vary by sector, but 15%-20% is typically good, while 5% is considered low.
Operating profit margin
Operating profit margin measures how much revenue a company retains after accounting for its operational costs. It indicates the efficiency of management in controlling operating expenses and generating profits from revenues.
In the example above, the company’s operating income was $14,000 and its revenue was $50,000.
To improve your operating profit margin, you need to find ways to increase operational efficiency and streamline your business processes.
Free cash flow
Free cash flow is the amount of cash left over after you’ve paid for your capital expenditures (CapEx). It indicates how much cash you have available to reinvest in your business, repay debts with, or distribute to shareholders after you’ve covered the costs of buying or improving your fixed assets.
You can calculate operating cash flow (OCF) using either the direct method or the indirect method. The most commonly used method is the indirect method, which starts with net income and adjusts for non-cash expenses and changes in working capital.
As you can see, net income is the starting point for calculating OCF and, by extension, free cash flow.
Gross profit margin
Gross profit margin measures your company’s profitability after accounting for its cost of goods sold (COGS). It indicates how much profit the company makes on each dollar of revenue before deducting any other expenses.
In our example, revenue was $50,000 and COGS was $25,000.
Your gross margin will be a lot higher than your net profit margin. Use it to assess how production costs impact your profitability.
Factors Influencing Net Profit Margin
Your net profit margin is a key measure of your business’s financial health, but it can be influenced by several factors. The four most significant ones are revenue generation, cost management, operational efficiency, and economies of scale.
Revenue generation
Increasing your sales volume can lead to higher total revenue, which, if you manage it effectively effectively, wiil improve your net profit margin. But you have to consider the associated costs of driving sales growth.
- Sales and marketing expenses
- Production scaling
- Promotional offers
If these costs increase too much with your revenue, your net profit margin may remain unchanged (or even decrease).
There is a way to drive sales without increasing your costs: price optimization. Increasing your prices can lead to higher revenue per unit sold. Done properly, it can even increase your sales (this is especially the case if you’re trying to position your product as a premium option).
The inverse may also be true. If you’re overcharging for an item and it isn’t aligned with your customers’ willingness to pay, lowering prices could drive so many additional sales that it’s worth letting your margins take the hit.
Cost management
High operating costs significantly eat into your margins, as a larger share of revenue is consumed by expenses. How you optimize your costs varies, depending on whether you’re looking at fixed costs or variable ones.
Fixed costs remain constant regardless of production volume. Examples include rent, salaries, and insurance premiums. To manage these, you need to bring them down by renegotiating contracts, finding less expensive alternatives, or cutting non-essential expenses.
Variable costs fluctuate with production output. Think: raw materials, direct labor, and utility costs associated with manufacturing. Lowering these requires you to find efficiencies in production processes (e.g. reducing waste), using technology to automate tasks, and ordering in larger quantities.
Operational efficiency
Streamlined processes enable your team to accomplish more in less time, increasing output without a corresponding rise in costs. In a lot of cases, they actually lead to lower production and operational costs because they eliminate unnecessary steps and automate tasks.
On top of that, if you make the right investments in technology, it can take the place of some of your manual labor and result in higher-quality products/services. The residual impacts are increased customer satisfaction and potentially higher sales as you improve your reputation and retain customers for longer.
Economies of scale
As you scale production, your average cost of producing each unit decreases. This reduction in costs translates directly into higher profit margins, even if sales prices remain the same or fall slightly. Larger production volumes enable businesses to negotiate bulk purchasing discounts with suppliers, further reducing your costs.
One consideration: While economies of scale can lead to increased net profit margins, this relationship isn’t guaranteed. Some research indicates margins don’t always rise as companies grow, and scaling beyond a certain point could lead to increased per-unit costs due to factors like overextension, management challenges, or resource limitations.
Strategies to Increase Your Net Profit
Increasing top-line revenue
Revenue growth has the potential for scalability, especially if you’re using a recurring revenue model and can shift your focus to retention once you’ve made a sale. Plus, focusing on revenue leads to market share growth and increases your brand recognition.
That said, pursuing higher revenue generally entails ramping up marketing, sales, and production, which can offset profit gains if you don’t have the resources or capacity to support growth. There may also be limitations due to market demand, competition, or pricing pressures.
A few strategies that maximize revenue generation while minimizing input costs:
- Train your sales team to effectively upsell and cross-sell.
- Transform your sales process to become more efficient and increase your win rate.
- Focus on retaining your current customers (acquisition is 5-7x more expensive than retention).
- Implement tools like CPQ to personalize lead engagement, make upselling easy, and protect your margins.
Whatever you do, assess your current capacity before scaling up to ensure you can meet increased demand without compromising quality or incurring excessive costs.
Effective pricing strategies
Pricing is a tough egg to crack. Price too high, and you risk driving potential customers away; price too low, and you might not make a profit or undervalue your product. Aligning pricing with product value is easier said than done.
Here are a few ideas:
- Tiered pricing helps you segment customers by offering different levels of features at different price points.
- Value-based pricing ties your product’s price to its perceived value, which you can determine through market research, customer surveys, and competitor analysis.
- Psychological pricing uses techniques like charm pricing (ending prices in 9) to make customers perceive the price as lower than it actually is, which drives more sales.
- Bundle pricing gives customers an overall discount when they purchase multiple products together.
- Usage-based pricing aligns pricing with consumption or usage levels, making it more flexible for customers.
On top of that, you should always be testing different price points to see if increases or decreases cause a significant change in demand.
Cost reduction techniques
The main advantage of this approach is that cost reductions can directly and immediately improve net profit margins.
There are plenty of ways to reduce costs:
- Streamlining operations
- Outsourcing non-core activities
- Optimize the use of facilities and resources
- Securing better terms for leases or service contracts
- Buy raw materials in larger quantities to benefit from price breaks
Keep in mind when executing these strategies that there’s a limit to how much costs can be cut without affecting product quality or employee morale. Excessive cost-cutting could harm customer satisfaction and reduce your company’s capacity to grow.
Streamlining operations
You might want to look into your current operations and see where technology can fill in the gaps. Sales, marketing, customer service, production, product development, and finance are all areas you should evaluate.
To give you one example, you might implement an AI chatbot to reduce your sales and support team costs. Instead of wasting an employee’s time for every small inquiry, your customers can interact with the chatbot to either get pre-qualified and routed to the appropriate seller or summarize their issue and get routed to one of your support agents.
People Also Ask
Is net income the same as net profit?
Yes, net income and net profit are terms that are often used interchangeably to refer to the same financial metric. Both represent the amount of money remaining after all expenses, including operating costs, taxes, interest, and depreciation, have been subtracted from total revenue.
Where is net profit on a balance sheet?
Net profit is not directly listed on the balance sheet. Instead, it is reported on the income statement and subsequently contributes to the equity section of the balance sheet under retained earnings. This reflects the cumulative net income retained by the company after distributing dividends.
What is the net profit ratio?
The net profit ratio, also known as net profit margin, measures the percentage of remaining revenue after deducting all your business expenses. You calculate it by dividing net profit by total revenue and multiplying by 100. For example, if a company does $100,000 in sales and is left with $20,000 at the end of the year, its net profit ratio would be 20%.