Gross profit and net profit of a firm are closely related to one another and help business owners to prepare their annual income statement.
Both of these factors are indicative of a company’s financial health. Consequently, prospective investors and business owners should be well-aware of the implications of and differences between both these metrics to judge a company’s performance more effectively.
In this article
What is Gross Profit?
The gross profit of a company can be described as the difference between the total revenue and cost of goods sold (COGS). Revenue is the aggregate of money earned by a firm within a specific financial period.
Notably, revenue is often listed as net sales if it is inclusive of discounts and refunds from returned goods. On the other hand, COGS is the cost associated with the production and manufacture of goods and includes these items –
- Direct labour
- Direct raw material
- Expenses for repair
- Shipping charges
- Cost of equipment
- Production utilities
In simple words, gross profit denotes a venture’s profit before its expenses are deducted and happen to be an item under Trading Account. Notably, gross profit comes in handy for determining the efficiency of a firm is using its raw material, labour and production supplies. In other words, it is useful in emphasising the firm’s efficiency pertaining to production and pricing activities.
Gross profit does not, however, reflect how much a company will spend to pay off its shareholders or reinvest in the business. Regardless, it is indispensable for calculating the net profits of the company accurately.
Gross Profit Calculation
In order to find the gross profit of a company, one needs to compute its earnings before deducting its expenses. The formula is expressed as –
Gross Profit = Revenue – Cost of Goods Sold
Referring to this example below can proffer valuable insight into the gross profit calculation.
Suppose, Green Private Limited earned Rs.120000 in a financial year, and its cost of goods sold amounted to Rs.40000. So, its gross profit would be –
Gross profit = Revenue – COGS
= Rs. (120000 – 40000)
To understand the key difference between gross and net profit, let’s proceed to find out the fundamentals of net profit in brief.
What is Net Profit?
It is the profit left after the COGS, operating expenses, interest and tax have been subtracted from a company’s aggregate revenue. It is a component of Profit and Loss Account and is also known as a ‘bottom line’ for its position in income statements.
Notably, the profit also includes additional income like interest on investments and sale proceeds, wherein, the operating expenses include –
Net profit plays an essential role in determining a company’s profitability and is extensively used to find out firms’ ability to convert sales into profits. Furthermore, net profit helps owners to develop requisite business strategies and make adjustments to improve their financial standing and profitability. Likewise, it allows creditors to gauge the profitability of specific companies effectively.
Net Profit Calculation
To calculate the net profit of a firm, one needs to be aware of its gross profit because the net profit formula is expressed as –
Net Profit = Gross profit – Expenses
The example below offers a more detailed idea about the same.
Assume that the company, JZ Private Limited accrued a gross profit of Rs.8000 in a financial year and has accumulated expenses as follows –
- Rent = Rs.1000
- Utilities = Rs.250
- Salary = Rs.2000
- Office supplies = Rs.300
- Depreciation cost = Rs.500
- Interest = Rs.250
- Tax = Rs.1000
Based on the information, the total expenses of the firm would be = Rs.5300 (summation of all the expenses mentioned above)
As per the net profit formula,
Net Profit = Rs. (8000 – 5300)
Notably, if the calculations from the formula give negative results, it is registered as a net loss. Also, a firm with a substantial gross profit may still incur a net loss as it entirely depends on the firm’s accumulated expenses.
Now, to deduce the differences between the two metrics, the following is a debate of gross profit vs net profit pertaining to financial treatment.
Gross Profit and Net Profit on Income Statement
The excerpt from the income statement of Tata Steel as of 30th March 2019 shows the placement of gross profit and net profit.
|Cost of Revenue||62,97,16,000|
|Income prior tax||15,90,57,200|
|Income from on-going operations||9,18,72,900|
Having gained some perspective about the fundamentals of both, let’s move on to the gross profit and net profit differences.
Difference between Gross Profit and Net Profit
The following table highlights the points of differences between gross profit and net profit.
|Parameter||Gross Profit||Net Profit|
|Definition||It is the profit derived after subtracting manufacturing expenses from total earnings.||It is the available profit after all expenses, taxes and interest have been deducted from gross profit.|
|Objective||Gross profits help to minimise costs.||Net profits help to estimate the proficiency of firms.|
|Function||It helps to ascertain rough profits.||It helps to ascertain actual earnings accrued in a financial period.|
|Reliability||It does not provide a precise idea about the available profit and hence does not help business strategies.||It is comparatively a more dependable parameter to formulate business strategies.|
|Financial Treatment||Gross profits appear on the credit side of Trading Accounts.||Net profits appear on the credit side of Profit and Loss Account.|
|Inclusions||It comprises overhead costs and taxes.||It comprises operating expenses, taxes and interests.|
|Formula||Gross Profit = Revenue – Cost of Goods Sold||Net Profit = Gross profit – Expenses|
Profitability can be defined as a firm’s ability to generate earnings through all its operational activities. It further tends to indicate that a firm has been using all its resources efficiently to optimise revenues.
Business owners, financial analysts and investors can use financial metrics like profitability ratios to ascertain the proficiency of firms.
The most extensively used profitability ratios include –
- Gross profit ratio
It reflects the relationship between a firm’s gross profit and net sales revenue. It suggests the amount of income that a firm has to generate to cover its operating and non-operating expenses.
It is expressed as –
Gross profit ratio = (Gross profit / Net sales revenue)
- Gross profit margin ratio
Besides highlighting the relationship between a firm’s gross profit and net revenue, the ratio also helps to analyse its efficiency. It comes in handy in assessing the proficiency of a firm in using raw materials, manufacturing equipment and labour.
This ratio is expressed as –
Gross profit margin ratio = (Gross profit / Net sales revenue) x 100
- Net profit margin ratio
This profitability ratio indicates a relationship between net profit post-tax and net sales. Notably, not all non-operating earnings and expenses are taken into consideration.
It can also be expressed in the form of percentage and is known as the net profit margin ratio. It is effective in estimating the profit trends of a firm and also helps to compare it with its contemporaries.
It is expressed as –
Net profit margin ratio = (Net income / Revenue) x 100
Let’s take a look at the example below.
Suppose Truckers Private Limited’s Revenue stood at Rs.500000 and gross profit was Rs.300000 in a financial year. Also, the accrued expenses amounted to Rs.83000 in the same year. Based on this information –
The gross profit margin ratio would be –
Gross profit margin ratio= (Gross profit / Net sales revenue) x 100
= (300000 / 500000) x 100
Similarly, the net profit margin ratio would be –
Net profit = Gross Profit – Expenses
= Rs. (300000 – 83000)
So as per formula,
Net profit margin ratio = (Net income / Revenue) x 100
= (217000/500000) x 100
Usually, a company with a higher net profit margin is deemed financially more fit and proficient. Resultantly, it attracts the attention of potential investors and keeps shareholders satisfied. Also, it comes in handy for comparing two companies with varying profits more effectively.
Hence, both gross profit and net profit play an essential role in determining a firm’s financial standing and performance. Gross profit offers a fair idea about the proficient use of raw materials, labour and capital. Also, a higher gross profit ratio indicates that operational cost is low.
On the other hand, net profit is a useful metric for investors and financial analysts. It enables them to measure a firm’s proficiency from various aspects. For example, business owners rely on it to analyse their firm’s profitability, while creditors determine its repayment capability. Likewise, business analysts use it to determine business efficiency.