The main purpose of any business entity is profit generation. Any business undertakes varying operations to earn revenues and work profitably. The operating activities of a business form the accounting cycle around the financial year. The activities are recorded in books of accounts and used to prepare the financial statements of the company.
Different financial statements record varying operating activities. The operating activities of a business entity are consolidated in the income statement or profit & loss statement of the business entity. The company’s income statement represents all the business entity’s revenues, expenses, and net profitability.
The profitability of the company is a very important item in the financial metrics of the business entity because it represents if the company’s operations are going well or not. The external stakeholders use the profit to know if they should invest in a business. On the other hand, the profit helps the management to plan future investments and business expansion.
This blog will help you understand the net profit, the most crucial measure in the income statement of a business entity. You will know how to calculate the profit and the different types of profit along the income statement.
What Is Net Profit?
Net profit or net income can be defined as,
It is the net accounting profit of the company that is left after meeting all the expenses and financial obligations for a financial year. The business’s net profit is calculated by subtracting the revenues, interest, and tax.
The net profit or net income is recorded as the last item on the business’s income statement. The part of net profit is carried forward to the statement of retained earnings, and the remaining is paid as dividends to the shareholders.
Purpose Of Net Profit Calculation
The main purpose of calculating the net profit is to know if the business is working profitably. A public company requires to calculate the net profit for the true and fair presentation of financial metrics for the shareholders(owners of the company). On the other hand, the company’s internal management needs the metrics for planning the business expansion.
The sole proprietorships and partnership businesses also calculate the net profit that is shared within the partners or used for growing the business.
How Does Net Profit Impact Financial Health Of The Company?
There is a general conception that net profit is related to cash earnings. However, there is no such concept in the accrual basis of accounting. A company might have thousand dollars as net profit but nothing in the cash reserve. Instead, net profit reflects an increase in shareholder’s equity by dividends and net profit.
The net profit can be defined concerning the impact as,
Net profit is the computation of the overall impact of all business transactions within a financial period on the owner’s equity.
The impact of net profit can be shown as follow:
Assets(Increase) = Liabilities(Decrease) + Owner’s Equity(Increase)
The assets of the company are increased when net profit is calculated. The liability might be decreased as the net profit will help offset some of the company’s liabilities.
The impact of profit on owner’s equity is increasing in it. As the retained earnings and dividends are recorded in the owner’s equity, the company’s net profit will increase.
Difference Between Net Income And Net Profit
Net income is the absolute measurement of the earnings of a business entity for a given period. The net income represents the company’s revenues minus all the expenses of the company. The interest and tax are also deducted from the company’s revenues. The net income balance can be negative or positive. The negative outcome is recorded as net loss, and a positive outcome is recorded as net profit.
So the difference between the two is their scope. Net income is a greater concept which covers net profit and loss as well. Net profit is the net increase in the owner’s equity due to operations and transactions of the company for the financial period.
How To Calculate Net Profit?
Let’s see how to calculate the net profit. The net profit for different business entities is calculated differently. A merchandising business usually prepares a trading and Profit/Loss account. The trading account represents the subtraction of direct expenses from the revenues leaving behind the gross margin. It is carried forward, and the operating expenses are subtracted to reach the entity’s net profit.
On the other hand, the statement for the cost of goods manufactured and goods sold is prepared by most manufacturing businesses. The cost of goods sold found is then subtracted from the sales in a separate income statement. The general, administrative, and marketing expenses are deducted from operating income to find EBIT. The interest expenses and taxes are deducted to reach the net profit of the business entity.
The income statement will look like this,
|(-) Cost Of Goods Sold
|(-) General & Administrative Expenses
|(-) Selling & Marketing Expenses
|(-) Interest Expense
|Income Before Tax
|(-) Tax Expense
So, we can explain the formula for calculation of net profit as,
Net profit = Total Revenues – Total Expenses
Net Profit = Gross Profit – Operating Expenses – Interest & Tax
Net Profit = Operating Profit – Interest & Expenses
Let’s recall some terms that are included in the income statement to reach the net profit.
Revenues are the total sales or proceedings from the company’s operations during the financial period.
The cost of goods sold is calculated by adding the closing inventory from last year to the current year manufactured or purchased inventory. The closing inventory of the current financial period is subtracted to calculate the cost of goods sold.
The gross profit is the first profit figure calculated along with the income statement. It is calculated by subtracting direct expenses from the net revenues. The direct expenses can be the cost of goods sold, transportation in, purchases, direct material, direct labor, etc.
The operating expenses represent all the expenses incurred by the business entity to keep its business operational during a financial period. The operating expenses are subtracted from the gross margin. The most common examples of operating expenses are utilities, office supplies, rent, salaries, wages, general & administrative expenses, and marketing & selling expenses. Depreciation is a non-cash expense that is also deducted from the gross margin.
Operating profit or earnings before interest & tax is derived by subtracting the operating expenses from the gross profit margin.
When the business entity has taken a bank loan or capital loan having a material impact on the company’s income, interest is recorded as a separate line item instead of adding as a part of operating expenses. The interest expenses include all the interest expenses on long-term liabilities.
Income Before Tax
The interest expense is subtracted from the operating profit or EBIT, and the income before tax is calculated. The income before tax is also a significant measure. The calculation of income taxes is based on the income before tax.
Tax expense is calculated on the income before tax. The tax rates are applied according to income, type of business, and nature of corporate taxes.
The final result is net profit calculated by subtracting tax expenses from the income before tax. The net profit can be distributed among the shareholders or plowed back for business expansion.
Example Of Calculating Net Profit
Let’s take an example of a manufacturing company to calculate the net profit.
Company Union & CO. had made total revenues of $500,000. The cost of goods sold was calculated and found to be $250,000. The general & administrative expenses, selling, marketing, and all other operating expenses were $75,000: 30,000 were other expenses, 25,000 G & A, and 20,000 as selling & marketing expenses. The interest expense was found to be $8000. The tax rate is 9.5% of the income before tax.
Calculate the net profit for the company.
Company Union & Co.
For the period ending Dec 31st, 20XX
|(-) Cost Of Goods Sold
|(-) General & Administrative Expenses 25000
|(-) Selling & Marketing Expenses 20000
|(-) Other Operating Expenses 30000
|(-) Interest Expense
|Income Before Tax
|(-) Tax Expense( 167000 X 0.095)
The net profit is used further for the financial ratio analysis and calculation of profitability ratios. The net profit margin tells how much a company is saving on every $100 of the revenues. The profit of the company is carried forward to a comprehensive income statement. The adjustments for income from discontinued operations, other income from external investments, etc., are made to calculate the income. For multinationals, the net profit is used for the consolidation of income statements.
The earning per share is also calculated by net profit. Now you can explain what net profit is, how it is calculated, and what it represents in the company’s financial statements.