Net profit is a perfect statistical element which has the capability to soak all business decisions in itself and present a holistic picture of the business within a few numeric values.
Whether it is a net loss or net profit, it does not leave the company unaffected.
In case of losses, the company might need to cut down on expenses and decrease the cost of production and eliminate additional expenses.
However, in the case of net profit, a company dreams to flourish and accelerates production by hiring new employees and motivating the employees and employers to work in tandem with each other.
Thus, net profit is a much wider concept than gross profit since it(net profit) is inclusive of indirect expenses and indirect incomes.
A good net profit margin indicates the proximity of converting sales into actual profits.
But, to be able to understand this evaluation in detail, we need to go through the fundamental net profit meaning.
Hence, without any further ado. Let us dive right in.
The two main profitability metrics of any company include gross profit and net profit. Gross profit is a representation of the income or profit that remains after the production costs are subtracted from the revenue.
Revenue refers to the amount of income generated from sale of the goods and services of a company. Gross profit also helps investors to determine how the total profit a company earns from the sale of its goods and services. Gross profit is also known as gross income.
On the other hand, net profit is the profit that is remaining after all expenses, costs and taxes have been deducted from its revenue. With the use of net income or net profit, investors determine the overall profitability of a company which indicates how effectively a company is being managed.
The basic purpose of net profit is to indicate the success of a business venture. Aside from that it also talks about the company’s ability to repay its debts and reinvest. The various uses of Net Profit for different stakeholders are as follows:
For the owners: It helps the owners in computing the profit of the company once tax is paid in full.
For the competitors: Business competitors of a company look at the net profit to gain more insight into their rival’s profitability and proficiency.
For the investors and shareholders: Net profit helps in judging the revenue-generating capacity the firm possesses based on its net profit. A firm which is sustainable has a higher chance of attracting potential investors and shareholders.
Since it is deemed necessary for the growth of a firm, companies are always trying to improve it. Increasing the sales volume and reducing the overhead expenses are among the few proven ways to enhance the net profit of a business firm.
As mentioned above, net profit shows the sales amount after all of the following are subtracted from the company’s total revenue:
Notably, the total revenue can be described as the total sales minus the discounts and the refunds. On the other hand, the operational expenses and the overhead expenses are also indicative of the cost of selling and delivering the product.
The net profit formula is as follows–
Net Profit = Total Revenue – Total Expenses
In order to calculate the Net profit of a company, its total expenses are subtracted from the total revenue that is generated.
Let us take Makati Private Limited and Wafira Private Limited to find out how the net profit margin is calculated.
Income Statement of Makati Private Limited
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Net Profit Margin of Makati Private Limited = (Net income / Revenue) x100
= (146400/250000) x100
= 58.56%
Income Statement of Wafira Private Limited | ||||||||||||||||||
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Net Profit Margin of Wafira Private Limited = (Net income / Revenue) x100
= (274200/450000) x100
= 60.933%
Therefore, it is ascertained that the profit margin of Wafira Private Limited is higher.
Net profit and gross profit are both closely related and have an important role in financial accounting. Jointly, they help in determining and maintaining the financial records of a company.
For example, both net profit and gross profit help in analysing the financial health of the firm. Therefore, it is imperative for the owners of the company to understand them and the differences between them.
To start with, the owners and the investors must be clear about what gross profit and net profit mean.
For example, gross profit is the profit that remains with the company after its direct costs have been subtracted from its net sales. Also, gross profit is a temporary estimate of the firm’s revenue and helps in lowering the additional cost.
In contrast, surplus earnings remaining with the company after paying its taxes, interests and the operating taxes fall under the net profit. Net Profit also comes in handy for analysing the company’s sustainable profitability by helping with the calculation of the net profit margin.
To ease your understanding of the matter, here is an all-encompassing comparison chart of the same.
Serial No. | Basis | Gross profit | Net profit |
1. | Definition | The remaining profit after all the direct expenses are deducted from direct incomes | The remaining profit after all the indirect expenses are deducted from indirect incomes |
2. | Objective | It provides a company’s profitability in a particular year. | It shows the company’s position and performance in a particular year. |
3. | Advantage | It helps to restrict the company’s manufacturing/operating costs. | It signifies the availability of a company’s profit and reserves.
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4. | Reliability | It is a less reliable indicator since it is exclusive of indirect expenses and incomes, taxes, etc. | It is a true indicator of a company’s financial position with the effect of which a company can develop itself and make decisions about the expansion of the firm. |
5. | Credit balance | It gives the credit balance of a trading account. | It gives the credit balance of a profit and loss account. |
6. | Formula | Gross profit =Revenue-Cost of goods sold. | Net profit=Gross profit-expenses |
The net profit margin, or the net margin, is a measure of how much the net income or the profit is generated as a percentage of its revenue. It is the ratio of the net profit to the revenues of a company or a business segment.
Net profit margin is expressed as a percentage but it can also be expressed in decimal form. The net profit margin demonstrates how much of each rupee in revenue collected by the company translates into profit.
Net profit margin helps the investors to assess if the company’s management is making enough profit from its sales and whether or not the operating costs and overhead costs are under control.
Net profit margin is also one of the most important indicators of the company’s overall financial health. By tracking the increases and the decreases in the net profit margin, a company can evaluate whether or not the current practices are working and then forecast profits based on its revenues.
Owing to the fact that companies express net profit margin as a percentage rather than a rupee amount, it is also possible to compare the profitability between two or more businesses regardless of their sizes.
This metric also includes all the factors in a company’s operations, including the:
Investors can also assess if the company’s management is generating enough profit from the sales and whether or not operating costs and overhead costs are being controlled.
For example, a company can have increasing revenue, but if the operating costs are growing at a faster rate than the revenue, the net profit margin will shrink. Ideally, the investors want to see a track record of the expanding margins, meaning that the net profit margin generally rises over time.
Most public companies report the net profit margins both quarterly during the earnings release and mention it in their annual reports.
Companies can also improve their net profit margins over time and are generally rewarded with share price growth, as price growth is highly correlated with the earnings growth.
The net profit margin is calculated by using the formula given below:
Net profit margin = ((R-COGS-E-I-T)/R)*100
Where,
First, on the income statement, the cost of goods sold (COGS), operating expenses, other expenses, interest (on debt), and taxes payable must be subtracted.
After that, divide the result by revenue.
Convert the figures into a percentage by multiplying it with 100.
Alternatively, locate the net income in the bottom line of the income statement and divide that particular figure by revenue. After that, convert the figure to a percentage by multiplying it with 100.
Net profit margin considers all the costs that are involved in a sale, making it a very comprehensive and detailed measure of profitability.
Gross margin, however, simply looks at the costs of goods sold (COGS) and ignores other things such as the overhead costs, fixed costs, interest, and taxes payable. Operating margin also further takes into account all the operating costs but still excludes any of the non-operating costs
Net profit margin can be swayed by one-off items for example the sale of an asset, which would boost profits for the time being. Net profit margin does not hone in on the sales or the revenue growth. Furthermore it does not provide insight as to whether the management has been managing the production costs.
It is best to make use of several ratios and financial metrics when it comes to analysing a company. Net profit margin is normally used in financial analysis alongside the gross profit margin and the operating profit margin.
Overall, Net profit and loss account is a nominal account which is closed at the end of the financial year and the balance is transferred to the credit side of the balance sheet.
A good net profit margin increases the credit-worthiness of the company in the market and raises the goodwill of the company too.
An increase in the net profit due to operating profit is indicative of positive results but an increase in non-operating income leading to greater net profit does not mean that the company has succeeded in cost control and boost in sales.
A temporary rise might be there due to sale of any asset or reduction in liabilities.
Thus, an increase in net profit through daily operations of sales and cost control is a positive and wealthy sign of a developing company.
Net profit margin helps the investors in assessing whether a company's management is generating good enough profit from its sales and whether the operating costs and the overhead costs are being controlled. Net profit margin is one of the most essential indicators of the company's overall financial health.
Companies can improve their net profit margin by increasing the revenue. This can be done through selling more goods or services or by increasing the prices. Companies can also increase their net profit margin by reducing the costs
A good margin will vary from industry to industry, but generally 10% is considered to be the average net profit margin and a 20% margin is considered good (or “high”), and a 5% margin is considered to be low.
A negative net profit margin is when the production costs are higher than the total revenue for a specific period of time. This means that the company is spending way more money than it is supposed to, which is not the sign of a sustainable business. Many companies have had negative net profit margins depending on the external factors and the unexpected expenses.
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