Net Profit – How is it calculated?

You might have frequently heard financial analysts talking about a company’s net profit and its bottomline. The net profit, combined with the sales of a company, is an important measure analysts, creditors, and investors use when comparing companies from the same industry. What exactly does it mean? How is it different from the gross profit? And more importantly, how is it calculated? Let’s figure it out. 

What is Net Profit?

Net profit is the measure of a company’s profit after subtracting expenses, such as operating costs, interest, taxes, and depreciation, from the total revenue. Sometimes, it is used synonymously with the terms net earnings and net income. You must have heard market analysts mentioning the term ‘bottomline’ now and again. A company’s bottomline is its net profit. 

Net profit is an important parameter for businesses, it is especially important for investors as it helps them determine the overall health of the company. The net profit numbers show whether the business is making more than it is spending. The companies may use this metric to determine whether they should work towards expanding their business to clock more profits. 

Importance of Net Profit

Besides indicating the success of a company, the net profit means so much because:

● It helps business owners calculate the tax amount

● Business competitors use net profit numbers to figure out the company’s profitability and get wind of their strategies

● Creditors of a company to refer to its net income to gauge their loan repayment capability

● Investors and shareholders refer to the net profit numbers to judge its revenue-generating capacity to deem it worthy or unworthy of investment. 

These are just some of the reasons why the management focuses on improving the company’s bottomline. Some of the proven and no-brainer ways to do that are by increasing sales and reducing overhead expenses.

How is Net Profit Calculated?

You can calculate a company’s net profit by reading its income statement and doing some basic math. As per the definition, a company’s net profit is calculated using the following equation:

Net profit = Total revenue - total expenses

Total revenue is the difference between total sales and discounts and refunds. The expenses might include the following – operating cost, tax, interest, preferred stock dividends, operational expenses, and overhead expenses. 

If the inflow is more than the outflow, meaning the revenue is more than the expenses, then it is called net profit. However, if the opposite happens and the company is spending more than it is earning, it is said to be making a net loss rather than a net profit. 

Alternatively, if you know the gross profit of a company, you can subtract the total expenses from that number to get the net profit. 

Net profit = Gross profit - total expenses

Gross profit is the profit that a company makes after considering all the manufacturing costs. It is calculated by subtracting the cost of goods sold from the total sales. Gross profit tells you how efficiently a company is using resources to manufacture goods. It is another important metric to consider when you’re analysing a company’s financial performance.

Limitations of Net Profit

The net profit of big and small companies in the same industries can often have a massive difference. In this case, it becomes difficult to compare their net profit and analyse them. One way to avoid this situation is by comparing their net profit margin instead, which is a ratio. 

Profit margin is one of the famous financial ratios that help you calculate the profitability of a company from its revenue. It helps gauge the degree to which a company is making money by clarifying what portion of the company’s revenue was retained as profits. 

For example, if a company reports that it achieved a profit margin of 25%, it means it made Rs 0.25 for every rupee of sales generated. While there are many types of profit margins, the net profit margin is the most commonly used.

The net profit margin of a company is equal to its net income divided by the total revenue. It tells how much a company’s revenue was translated to profit after paying all the expenses. 

Net profit margin = Net profit / total revenue

Net profit margin is a better measure to compare the profitability of two companies and analyse their growth trends. It is used by creditors, analysts, and investors to gauge the financial health and growth potential of a company. 

However, one limitation that both net profit and net profit margin share is that both these measures vary from industry to industry, which makes it harder to compare businesses from different industries. For example, one simply cannot compare the decrease in the profit or profit margin of Ceat with that of Reliance Industries. Plus, across industries, a falling profit margin might not be a bad thing since the company might be considering improving its market share by reducing prices, thus sacrificing profits. 

FAQs

Q. What is the difference between profit and profitability?

Profit is an absolute number calculated by subtracting the expenses from the revenue. On the other hand, the net profit of a company tells you the profitability of the said company. Profitability is a percentage and a relative measure, which is equal to a ratio of profit and revenue. Profitability measures the efficiency of a business and determines whether or not the business is a success. 

Q. What is Profit After Tax (PAT)?

Profit after tax is calculated after subtracting tax from the net income made by a company. Net profit also excludes all the other expenses that the company incurs.

Q. Are profit and net income the same?

While both profit and net income deal with the income left after considering expenses, their definitions and contextual usage are different. While profit simply means the revenue remaining after considering expenses, it means different things after subtracting different types of costs. On the other hand, net income, also known as net profit, represents a specific type of profit (net profit).