The best way to answer these questions is with a thorough assessment of profitability.

That’s where gross and net profit calculations come in. These are two of the most important metrics for measuring your capacity to generate earnings relative to costs and expenses.

Let’s take a look at the differences between gross and net profit, and what they can reveal about the financial health of your business.

Gross profit: a general overview of profitability

You can calculate your company’s gross profit by subtracting the cost of the goods or services you sell from your total revenue, over a specific period of time. The equation looks like this:

Sales – cost of goods sold = gross profit

When determining the cost of goods sold (otherwise known as COGS), businesses take into account all of the processes involved in their production and delivery to customers, including:

• raw materials
• manufacturing
• packaging
• shipping and fuel.

Once you know your gross profit, you can divide it by your total revenue to calculate your gross profit margin – a percentage that shows exactly how much money is left over after you’ve covered your COGS.

This calculation will show you how efficiently you’re managing your resources – and where optimization is needed – so you can work toward a healthier bottom line.

Net profit: drilling down to profits after all expenses

The net profit calculation goes a step further by determining how much revenue remains after subtracting all expenses, including COGS.  Net profit reveals your precise profit per dollar of sales after deducting operating expenses, taxes, interest paid on debt, etc. In order to keep abreast of your financial status, it’s wise to calculate net profit every month.

Determining your net profit is crucial for a number of reasons, including:

• knowing how much you can safely pay yourself each month, or divide among your business partners;
• applying for a business loan, where net profit is an important part of the lender’s free cash flow analysis
• measuring performance  against the industry benchmark and your main competitors.

Protect your profits by ensuring you get paid

It goes without saying that calculating gross and net profits won’t be very useful if you’re having trouble collecting payment from your customers. Staying on top of accounts receivable is crucial for maintaining positive cash flow, turning a healthy profit, and growing your business.

Here are a few tips for ensuring timely payment:

• require payment up front, and only offer 30 day terms to clients who have proven their trustworthiness
• track invoices weekly, contact clients immediately after the payment deadline has been missed, and work together to set a new deadline
• suggest an installment program for clients who are encountering financial difficulties.

Tighter invoice collection combined with clear insights into profitability will pave the way to smarter, more efficient management – your key to long-term sustainable business growth.

The post Differences Between Gross and Net Profit (and Why Neither Matter Unless You Get Paid!) appeared first on Dudley & Associates, Chartered Professional Accountants.

To cover the costs of your business you need to sell enough goods or services to reach your break-even point. Knowing where that point is, and how long it will take you to reach it, can be fundamental to your success. This especially true if you’re thinking about starting or buying a business.

Calculate fixed and variable costs

The first step is to establish your fixed and variable costs.

Fixed Costs

Fixed costs are bills your business always has to pay, regardless of its level of sales. Also known as overheads, they could include:

• Salaries for permanent staff.
• Rent on your premises.
• Insurance.
• Interest on debt.

Variable Costs

These are costs that increase with your levels of sales – materials and production costs are two examples. Others include sales bonuses, part-time wages and freight.

Now work out:

• The total fixed costs bill for the year.
• An average overall variable cost for each product or service sold (the Variable Cost per Unit).

Some bills might be a combination of fixed and variable costs, such as a phone bill split between a line cost and toll call charges. Separate these bills into fixed and variable parts for greater accuracy.

If breaking them up is too time consuming, choose which element is greater in the bills and classify it as that. For example, if you don’t make many calls to mobile phones or outside your local area, you’d classify the phone bill as being fixed.

Determine your break-even point

Let’s assume you manufacture shoes with the following details:

• Budgeted fixed costs of $60,000.
• Average cost to make a pair of shoes is $110.
• Average sale price per pair of shoes is $250.

Calculating your break-even point requires the use of a few formulas:

1. Sales Price per Unit ($250) minus Variable Costs per Unit ($110) = Contribution Margin per Unit ($140).
2. Contribution Margin per Unit ($140) divided by Sales Price per Unit ($250) = Contribution Margin Ratio (0.56).
3. Fixed Costs ($60,000) divided by Contribution Margin Ratio (0.56) = Break-even Sales Volume ($107,142).

Based on these calculations, if you sell more than $107,142 of shoes you’ll make a profit. That equates to 429 pairs.

Using your break-even point

Once you’ve worked out your break-even point, the next step is to work out whether the sales volume you’ll need to break even is realistic and achievable.

You can also use your break-even calculation to see the effect of changes in costs on your business. If you were able to source cheaper materials and reduce the variable cost per pair of shoes, you’d need to sell fewer pairs to break even.

If your sales remained the same, you’d make more profit.

To be of real value to you, your fixed and variable costs calculations need to be accurate. Putting inaccurate figures into your break-even calculations will give you an inaccurate result. It’s worth investing time to work out your figures accurately.

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Taking the time to regularly review financial statements can help you assess and improve current performance, avoid risk and make scalable plans for future growth.

Protect your company’s financial health by learning your way around these three financial reports.

Cash flow statement

The cash flow statement is arguably the most important report for small busineses. Over 68% of small business owners fear losing their business due to a lack of available cash.

How can this financial report help you avoid such a dangerous pitfall? By revealing precisely where you’ve allocated cash – and if you’re at risk of running out of it.

Monthly examination of your cash flow statement can help you predict and forestall a “cash crunch” by tracking:

• The in and out flow of money for operational activities; investments (such as the purchase of office equipment or the sale of portfolio holdings); and financing (such as loan repayments);
• Whether your net operating cash flow is less than your profits after tax (which means you’re spending more than you earn);
• Overarching trends that show cash runs low in some months and higher in others, so you take steps to build a reserve and ensure continuous “cash on hand”.

Profit and loss statement

Your profit and loss statement (also known as an income statement) summarizes the revenue, costs and expenses your business has incurred over a month, fiscal quarter or year.

In order to give you an accurate overview of your financial performance, the profit and loss statement typically breaks down into three sections:

1. Your revenue (known as the “top line”).
2. The total costs of doing business, such as operating expenses, research and product development, and expenses associated with taxes and interest.
3. Your net income (the often quoted “bottom line”), which is what remains when the costs of doing business are subtracted from your top line revenue.

The profit and loss statement can be used to calculate a number of important key metrics, such as your gross profit margin, operating profit margin and operating ratio.

Balance sheet

The third invaluable financial report for small businesses is the balance sheet. The balance sheet summarizes what your company owns (assets), what you owe (liabilities) and the current value of your business to investors (shareholder equity).

What exactly is being “balanced” on the balance sheet? In simple terms, the assets you own must balance out against the money you’ve borrowed.

Your assets may include cash in the bank, short-term investments, accounts receivable, inventory, equipment and property.

Your liabilities may include a bank line of credit, accounts payable, wages payable, rent, tax, and utilities.

Together with the cash flow and profit and loss statements, the balance sheet provides crucial insight into your company’s operations and overall performance.

Final Tip

Have your accountant walk you through each report, so you’ll feel comfortable reviewing them independently on a regular basis. It’s well worth the effort! When you understand your company’s key financial data, you pave the way to smarter decision-making and more sustainable growth for your small business.

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