11 November 2020

Are you confident in your knowledge of net profit and how it affects your bottom line?

Simply put, net profit is the difference between your gross profit (revenue minus the cost of goods sold) and all of your business expenses. That definition alone is probably known to all business owners; it’s crazy to think that someone running a business is unaware of this concept.

But net profit is more than just a number you look for in your income statement (for most people, it’s the only figure that they look at). Apparently, there’s more to just knowing how much you’ve earned. For business owners, it’s also important to know how net profit translates to operational efficiency and how it gives a picture of how different aspects of business come together.

How well do you know your numbers?

Net profit and profitability

Profitability is capacity of a company to use its resources to generate revenues that are higher than its expenses. When you analyse financial statements and determine company performance as a whole, you look at profitability. You look at other things, too, such as efficiency, solvency, and market prospects. In short, there are many reports that you can use to measure the profitability of a business.

However, experts consider net profit as often the most truthful sign of profitability because it shows the total amount of revenue that exceeded the expenses during a particular period. Net profitability is the most important distinction because the amount of increased revenue you get does not necessarily signify increased profitability.

Your net profit in the eyes of your competitors and potential investors

Limited companies submit returns to the tax authorities, which is one of the ways competitors can see your net profit and give them a better understanding of your business and its level of profitability. Of course, you can do that, too. It’s useful to benchmark your performance against that of your competitors to help you set internal objectives, identify market opportunities, and even exploit competitor weaknesses.

For potential investors and shareholders, net profit is a crucial figure if you are looking at inviting investment in your business, or if you have shareholders. Naturally, strong and reliable net profit figures will give investors the idea that you’re a good business to invest in and that they will most likely get a return.

Net profit margin: An overview of your business potential

Do you know your net profit margin? It’s basically is equal to how much net profit is generated as a percentage of revenue. Meaning, the way to calculate net profit margin is by dividing your net profit by your total sales revenue.

Net Profit Margin = Net Profit / Revenue

Let’s say your business made £12,000 in sales, and it cost you £8,000 to make your products, and you spent another £2,000 on operating costs (overhead and taxes).

Net Profit = £12,000 – (£8,000+£2,000) = £2,000

Net Profit Margin = £2,000 / £12,000 = 16%

That means your business has a net profit margin of 16%. Another way of saying it is that 16% of your total sales revenue is profit.

So, what do you do with this figure?

As a general rule of thumb, a 10% net profit margin is considered average, a 20% margin is considered good, and a 5% margin is low. Aside from the fact that it helps investors evaluate if a company’s financial health, it’s also important in evaluating in lending decisions because it effectively shows the business’s potential net worth based on earnings. This directly impacts capital reserves, which means the higher the net profit margin, the more likely the business will be able to remain resilient in times of unexpected losses.

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