Gross profit is the total revenue taken in by a company, minus the direct costs of producing the product or service. Net income is the bottom line of what a company makes after subtracting all expenses that are incurred. Both gross and net profits are used to determine a company’s financial health.
To analyze the financial strength of a company, you have to look at the numbers. And there are a lot of numbers to consider. For a clear picture of a company’s financial health, you can’t just rely on total net sales. You also need other metrics, such as a company’s gross and net profit. But what do all of these numbers mean? How do they relate to the bottom line of a company?
Keep reading to learn what the differences are between gross and net profit, how to calculate each, and what these numbers mean for you as an individual and a business.
Gross profit vs. net income
To understand net income (or net profit), it’s important to distinguish it from gross profit, or gross income. However, it’s also important to highlight whether you’re talking about an individual’s or a business’s gross profit or net income.
|Gross profit||Total earned before taxes and other deductions||Total money from sale of goods minus COGS|
|Net income||Pay after deductions, insurance, and taxes|
Calculated for every pay period
|Money a company brings in after accounting for operating expenses, taxes, and depreciation|
*A company’s gross profit and net income are calculated quarterly and annually.
It helps to remember that the gross is always going to be the larger of the two numbers. The net income is always smaller because that number accounts for taxes and other deductions for an individual’s paycheck, or taxes and all other expenses for a business.
Total sales revenue vs. Gross profit
Sometimes gross profit is confused with total sales revenue or net sales. Total sales revenue refers to all of the income taken in from the sale of goods and services. This is the raw number of all the money a company makes from sales during an accounting period. To calculate gross profits, on the other hand, you take the revenue and subtract the cost of goods sold (COGS).
That gross profit number is often expressed as a percentage, in which case it’s referred to as the gross profit margin or gross profit ratio. The higher the margin, the better, as it indicates the percentage of revenue that surpasses the cost of goods sold. To calculate gross profit margin, simply take the gross profit and divide by the revenue.
What is an example of gross profit?
For a simple example of gross profit, let’s pretend we own XYZ Inc, and we sell coffee makers. In 2021, we made $300 million in net sales. Now let’s say we spent $100 million on direct costs to manufacture the coffee makers.
So we subtract the $100 million in expenses from the $300 million in revenue, and that leaves us with gross profits of $200 million. Or, expressed another way, it shows a 67% gross profit margin.
Now imagine we own JKL Corp., and we sell slot machines, which are expensive to make. In 2021, we also had $300 million in sales, but material prices went up and it cost us $350 million to make them.
This results in a negative gross profit of $50 million dollars. This example illustrates one way in which a business’s total sales don’t give you a clear picture of a company’s financial health.
What is net income?
Net income is what we think of as “take-home pay.” Let’s say you make a total of $4,000 a month, but you only take home $2,758 because taxes and other payroll deductions are taken out. That $2,758 is your monthly net income.
It’s much the same for companies, albeit a little more complex. With a business, you first look at the total revenue taken in from the sale of goods or services. From that number, you must deduct all expenses associated with running a business as well as making and distributing those goods and services to arrive at your net income (also known as net profit or net earnings). Once a business has calculated its net profit, that number shows how much money is available for use, such as reinvesting for growth.
How does this differ from a net profit margin?
As opposed to net income, the net profit margin describes net profit as a percentage of revenue. Basically, this number shows how much net profit a company has translated from revenue.
Because of this, net profit margin is one of the most valuable measurements of a business’s financial health. Are operating costs too high? How have management’s sales improved or hindered the company’s profits? Net profit margin shows how one company’s net profits compare to another, regardless of business size.
Why is net income important for individuals?
For an individual, calculating net income helps you come up with your monthly budget. For instance, it’s widely recommended that no more than 30% of your budget should be allocated to a rent or mortgage payment. So, if your gross monthly pay is $4,000, but you only take home $3,000, you wouldn’t want to spend more than $900 a month on rent.
Does your W-2 use gross or net profit?
Every January, you’ll receive your form W-2 Wage and Tax Statement. Each employer you work for needs to send you one as long as you have made at least $600, and you need it to file your income taxes. This form will state your total gross income for the year in Box 1.
To figure out your yearly net income, simply subtract the amounts in Boxes 2, 4, 6, and 17 from Box 1. If you have money taken out for health insurance or retirement, include those numbers as well.
Side point: If you’re in February and still haven’t received a W-2 from a previous employer, read this.
Why is net income important for businesses?
For a business, net profit is particularly important because net income represents the central line item in three main financial statements: the income statement, the balance sheet, and the cash flow statement.
Your net income calculation uses the company’s income statement, which is also used in the balance sheet and cash flow statement. Investors use these statements to determine the overall financial health of a company. Ideally, you end up with a positive net income. On the other hand, if you arrive at a negative net income, the business is in trouble.
What are the three main financial statements?
The government requires publicly-traded companies to publish these financial statements regularly.
- Income statement. The income statement shows the revenue a company takes in from sales, the expenses incurred during that period, and the net profit of the business. If it’s a publicly-traded company, it will also reveal the amount of earnings per share.
- Balance sheet. This provides a detailed account of a company’s assets, liabilities, and shareholder’s equity. A company’s assets need to equal the liabilities plus shareholder investment.
- Cash flow statement. The cash flow statement details how the money has “flowed” into and out of the business. It basically takes information from the balance sheet and income statement and reuses it to report whether there was a net increase or decrease in cash for the accounting period.
Do lenders look at gross or net income for loans?
If an individual is looking to get any kind of loan or a mortgage, loan providers will ask for his or her gross monthly or yearly income. It seems counterintuitive that they wouldn’t ask for your net income, since that’s actually the money you have to spend. However, that’s just one of the pieces of information they will look at before deciding to give you a loan.
For a business loan, among other factors such as cash flow and tax returns, banks will want to look at both your gross and net profit. While it’s important to show what your company is making from sales, if you’re not ultimately showing a net profit you may not be eligible for a business loan.
What about operating profit?
While calculating for gross profit and net income are important financial indicators of a business’s health, analyzing operating income gives you a unique perspective.
Operating income, or operating profit, is another line item on a company’s income statement. This calculation differs from net profit because it represents a company’s income after operating costs but before accounting for interest income and expenses, and taxes.
It’s another way of looking at a company’s financial strength. This can give a clearer picture of how well the company is being managed rather than just what gross and net profit indicate.
How do you calculate net income?
This calculation changes depending on whether you’re calculating net profit for an individual or company.
Individual net income
Starting with a person’s gross pay (keeping in mind that states differ), deductions can include state and federal income tax, Medicare, social security, and health insurance. The number you reach after subtracting those figures brings you to the net income.
Business net income
To calculate a company’s net profit, which is done on the income statement, you begin with the total revenue. From the revenue, you subtract the cost of goods sold (COGS); selling, general, and administrative expenses (SG&A); operating expenses (OPEX); depreciation and amortization; interest expenses; and any other costs. After these total expenses are deducted from the sales revenue, you arrive at your net profit or net loss.
Here is an example of Target’s income statement and expenses, so you can see how the numbers all tie together.
It can be hard to keep all of the business terms straight. You can refer to this glossary if you have any trouble keeping track of business expense terms.
- Cost of goods sold. COGS refers to expenses directly related to making a product or providing a service. This includes things like production costs, raw materials, and direct labor. Items such as advertising expenses, distribution costs, and overhead costs are not included in this line item.
- Selling, general, and administrative costs. SG&A costs encompass the operating expenses of running a business that are not directly involved in the production of goods and services. Included are items such as rent, salaries, and marketing and distribution costs.
- Operating expenses (OPEX). Sometimes you will see operating expenses as a separate line item from SG&A. But oftentimes, operating expenses are included with the SG&A costs. For the purposes of this article, the terms are used interchangeably.
- Depreciation and amortization. These are examples of non-cash expenses companies have. Depreciation refers to fixed assets like equipment. It’s a way of allocating money each accounting period throughout the lifespan of the asset, rather than reporting the total cost upfront. Amortization is similar but concerns intangible assets like patents.
- Tax expenses. These are pretty self-explanatory. Just like you and I, companies have to pay income taxes to state and federal governments too.
- Other expenses. These costs can be anything not covered by the above categories that don’t include the day-to-day running of the business, such as legal expenses.
- Analyzing a company’s gross profit vs. net income provides valuable information about a business’s financial health.
- Gross profit is the total revenue of goods and services sold, minus the direct costs to make them.
- Net profit is the amount of cash left over after subtracting all business expenses from the total sales.
- Operating income shows your profit before accounting for taxes and interest expenses.
View Article Sources
- What are bonds? — U.S. Securities and Exchange Commission
- Topic No. 403 Interest Received — IRS
- Instructions for Forms 1099-INT and 1099-OID — IRS
- Do I Have To Pay Taxes On My Checking Account? — SuperMoney
- Savings vs. Money Market? Which Account Fits You Best? — SuperMoney
- Tax Relief Companies: Reviews & Comparisons — SuperMoney
- How to Calculate Your Adjusted Gross Income — SuperMoney
- Average Millennial Income Is Up, But At What Cost? — SuperMoney
- What is the Difference Between Payroll and Income Taxes? — SuperMoney
- Tax Preparation Firms: Reviews & Comparisons — SuperMoney