Understanding the difference between net income and profit is vital for business owners in any industry.
We’ll explore net income and profit to help businesses better understand these crucial financial markers.
What is net income?
Net income, also called net earnings or net profit, is equal to the sum of total income after expenses have been deducted. Net income is derived from various calculations, including total revenue, expenses and income streams during a specific timeframe. Additional streams include asset sales, amortization of assets, one-time payments for special occurrences and taxes. Expenses might include the costs associated with manufacturing products or interest paid on business loans.
Since net income is calculated after expenses, it’s considered an excellent indication of your business’s financial standing. To ensure your net income is accurate, you’ll need to track income and expenses consistently. Over time, you can compare net incomes for each year to determine whether the business has grown as expected or has remained stagnant.
Analysts and investors who use net income to assist with company evaluations often consider the specific calculations used to determine the company’s taxable income in addition to net income totals. This is because net income figures may be manipulated through hiding expenses or other unethical techniques.
Did you know? Some common expense fraud examples are fictitious purchases, padded reports, and inflated costs submitted for reimbursement.
What is profit?
Profit is the financial gain your business retains after you’ve taken care of expenses, taxes and other associated costs. To calculate your profit, subtract total expenses from your revenue. Profit is important because it tells an owner how the business is performing.
If your business has any income, you have profit, but separating your profit into categories helps calculate your business’s true financial standing.
There are three different profit types:
- Gross profit
- Net profit
- Operating profit
List each profit type on your business’ income statement to give stakeholders insight into your company’s overall performance. Here’s a closer look at calculating each profit type and why these numbers are crucial.
Gross profit, or gross income, is the total income from sales after you’ve subtracted all costs related to making and selling goods. For service-based businesses, this would be the profit after subtracting costs related to providing services.
Gross profit totals come in handy when reviewing variable costs within your business. Variable costs are any costs that fluctuate based on output levels. Gross profit does not include fixed costs, such as human resources or equipment.
These are some examples of variable business costs:
- Employee commissions
- Shipping costs
- Credit card fees for customer transactions
Sales totals are generally the first line item on an income statement, with the cost of goods sold listed next. This is the formula for gross profit:
Total sales – cost of goods sold = gross profit
Tip: Make sure you understand fixed vs. variable expenses. A fixed expense doesn’t change; it’s a set amount you pay regularly. Variable expenses can change based on numerous factors, so you can’t always predict what they will cost.
After you’ve deducted all expenses – including taxes and interest – the income left is called net profit or net income. Owners and stakeholders often rely on net profit numbers to give the most accurate picture of how well a business is doing financially.
In some cases, however, the net profit figure can be misleading. While net profit shows how much cash a business generates, profitability also depends on how the generated cash is invested.
Here’s the formula you would use to determine your business’s net profit:
Operating profit – taxes and interest = net profit
Before determining your net profit, you need to calculate your operating profit. Operating profit is the amount left over after subtracting operating costs from gross profit.
Unlike gross profit, operating profit includes both fixed and variable operating costs. Operating expenses for your business might include administrative costs and costs related to general business needs.
Operating profit is often referred to as “EBITDA,” which stands for “earnings before interest, tax, depreciation and amortization.” Here’s the formula you’d use to calculate operating profit:
Gross profit – operating expenses = operating profit
Did you know? The top small business accounting challenges include managing cash flow, covering unexpected expenses and analyzing finances.
Profit in small businesses
In the small business world, profit is considered direct income. If your income statement shows a higher expense number than profit, this is the No. 1 indicator of financial loss.
To get the most accurate representation of your business’s financial standing, take the time to analyze all three profit types. This analysis is conducted through the profit margin, a ratio of your organization’s profit divided by its revenue. The profit margin will give a detailed look into how well your business manages incoming revenue.
Example of net income vs. profit
Profit can be used as a general reference to several different figures, while net income is a specific profit type.
For example, say Company Z listed its gross profit for 2021 as $100,000. This figure equals revenue minus the cost of goods sold.
However, Company Z’s net income is reported as $45,000. This total is the amount left over after operating costs and tax payments have been deducted from the company’s gross profit.
FYI: Net income is always anticipated to be lower than gross profit.
How to track net income and profit
The best way to track your business’s net income and profit consistently and accurately is through accounting software. While most software providers offer to track totals, business owners must assess any accounting solution’s reporting capabilities.
We’ve compiled a list of the best accounting software, but the provider you choose will ultimately depend on what’s most important for your business. Take a more in-depth look at three excellent small business accounting software solutions.
QuickBooks Online is one of the most popular accounting software solutions, and it tops our list as an excellent choice for growing businesses. The software has been around for almost 20 years and has features to support almost any business type.
Here are some of the top QuickBooks Online features:
- Automatic bank feeds: QuickBooks comes with automatic bank feeds to help you track transactions.
- Direct invoicing: QuickBooks includes a Gmail app function to send invoices directly from your email.
- Live bookkeeping service: You can use a live bookkeeping service for a $500 fee and a monthly rate based on your average expenses.
- Inventory features: Depending on the plan you choose, QuickBooks also provides inventory management. You can add inventory images, track inventory through the software, and bundle items often sold together. This feature is especially helpful for businesses that manage large inventory quantities.
For more information, read our in-depth QuickBooks Online review.
If you run a project-based business, FreeAgent should be on your list as an accounting software option. These are some of FreeAgent’s features:
- Recurring invoices
- Automatic thank-you emails following customer payments
- Software timer for tracking time spent on projects
This software also offers a bank reconciliation tool that makes it easier to match transactions. Reporting is simple, with the option to run detailed financial reports like profit and loss statements and balance sheets. FreeAgent comes with a mobile app to help you consistently track account activity, claim mileage, and keep tabs on billable time.
For more information, read our full review of FreeAgent.
If your business operates on a very small scale – with fewer than 10 employees – consider Zoho Books for your accounting needs. Zoho Books offers inventory tracking and project management and is more affordable than most software providers. While it’s great for very small businesses, Zoho Books can scale with growing businesses and organizations of all sizes.
Here are some of the features we love:
- The option to convert estimates and orders into invoices
- The option to schedule invoices to be sent later
- The option to send invoices by snail mail
- Compatibility with payment processors like PayPal, Braintree, Stripe and Square
To learn more, read our in-depth Zoho Books review.
Avoiding the temptation to process financial data manually
Regardless of your business size or industry, accounting software is one of the best tools for tracking profitability. It can be tempting to start processing financial data manually, especially if you run a microbusiness. But human error is inevitable, and it helps to have an automatic process in place before your business begins to scale. Assessing different types of profit can be complex, and good software is your best bet to keep the analyses as straightforward as possible.
Article Source: https://www.business.com/articles/net-income-vs-profit/