As a small business owner, you can be advised to gauge your incoming cash and profits using a variety of metrics, including gross profit and net income. The distinction between gross and net income may not be well-known to many small business owners. These are two crucial criteria for evaluating business performance. Knowing this difference is essential to comprehend the financial health of your company. So, what exactly does gross profit vs. net income mean? What’s the difference, and which one is the best indicator of your company’s financial health?
Gross Profit vs. Net Income – Definition
Let’s first understand the definition of gross profit vs. net income.
The amount a business makes before deducting any costs is known as gross profit. The best way to describe it is as the total revenue from sales of goods and services over a given time period, less the direct costs of producing the thing or rendering the service. It includes all items sold for computing total sales. It does not include sales of fixed assets like buildings or equipment. Gross profit is also known as “gross earnings” or “gross income.” It is the sum that appears in the “gross profit” part of a profit and loss statement.
On the other hand, a company’s net income is calculated after deducting all of its expenses from the amount of money it makes during a certain time. Net income is also known as net profit. After taking into account both positive and negative cash flows, calculates the real profit your business made in relation to revenue. As the final line on your income statement, net profit is frequently referred to as the bottom line of your business. To put it another way, you subtract expenses from the top-line number, often known as revenue, to get the net income.
How to Calculate Gross Profit vs. Net Income?
Your income statement can be used to compute both gross and net profit. The total revenue and cost of items sold for your business are displayed on an income statement together with operational costs, interest, and taxes.
The gross profit equation is:
Gross Profit = Revenue – Cost of Goods Sold
Revenue in the equation stands for the entire amount of money made from product sales, and COGS stands for direct costs of manufacturing goods, which include expenses for labor, raw materials, equipment, and shipping.
Starting with net revenue, you can then deduct operating expenses like as rent or mortgage payments, material costs, personnel wages, and more to arrive at net income.
The net income equation is:
Net Income = Total Revenue – Total Expenditure
Example
Consider Richard Textiles, a merchant of clothing and materials, which generated a $500,000 gross income for the year. Customers returned $35,000 in goods in that same year. Moreover, Richard Textiles had a $100,000 cost of goods sold.
Richard Textiles’ gross profit for the year in question would be calculated as follows:
Net sales = Gross sales – Returns
= $500,000 – $35,000
= $465,000
Gross Profit = Net sales – Cost of goods sold
= $465,000 – $100,000
= $365,000
Let’s assume SG&A costs totaled $75,000 for Richard Textiles, and interest costs came to $5,000. The business’s net profit would be calculated as follows:
$365,000 in gross profit less $75,000 in SG&A costs and $5,000 in interest costs equals a net profit of $285,000.
“Do you want to learn more about “Net Income“
Why Gross Profit vs. Net Income is Essential for Business?
When it comes to gross income, business owners can utilize it for calculating sales over a period of time. It’s useful for determining their market share as well as patterns and seasonality of their sales over months and quarters. It helps them to assess how well your cost of goods sold is under control. It also helps them to ascertain whether the pricing of your goods or services is reasonable.
However, it doesn’t reveal to owners if they actually made or lost money over a certain period of time.
On the other hand, when businesses consider net income, they can easily understand the profitability proportions. It helps in understanding how much money the company is losing. Owners and managers can use net income to find ways to enhance their company even though it cannot tell them whether sales are increasing or decreasing.
Net income also helps businesses to measure their profit margin. It is also useful in making budgeting decisions. Moreover, net income plays a key role in valuing enterprises, assessing a business’ loanability, and making investment decisions.
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Frequently Asked Questions
What is gross vs. net income for a wage earner?
Gross income for a wage earner is the sum of any pay or wages that are paid to them by their employer before any deductions are made. On the other hand, net income refers to the remaining earnings after all payroll taxes and retirement plan payments have been subtracted from gross pay.
What is gross vs. net income for a business?
Before deducting selling, administrative, tax, and other costs, a business’s gross income is the amount it makes from the sale of its products or services. Net income is the remaining earnings for a business after all costs have been subtracted from sales.
Which is a more reliable factor between gross and net income?
Net income is a more reliable factor for making business decisions. It provides true profit a business is making. Gross income does not include taxes, expenses, and any interests. So, it is not helpful in financial decisions.
What is the formula to calculate Gross Profit?
You can calculate the gross profit by using the following equation:
Gross Profit = Revenue – Cost of Goods Sold
What is the formula to calculate Net Income?
You can calculate the net income by using the following equation:
Net Profit = Gross Profit – Expenses
