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Lost on Understanding Net Profits? Learn More Here

written by: Steve McFarlane•edited by: Jean Scheid•updated: 5/18/2011

Net profit is an important figure in the eyes of business managers, stakeholders, and financial analysts. Find out what it is and how it's calculated in this guide which also takes a look at net ratios and margins.

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    No figure seems more important to business stakeholders and those that peruse their financial statements than net profit. As a matter of fact, it is almost the first figure that draws the eye on financial and income statements. That is because it tells whether the operation is providing a positive return on the capital that was invested. In this article, we answer the question, "What is net profit" and how it is calculated.

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    Definition

    Calculating Net Profit Net profit consists of all sales minus all costs including cost of goods sold, administrative expenses, and salaries and, in some cases, taxes and interest expenses on debt servicing. In essence, it is the net of sales minus all the costs of producing a product or service and delivering that service to the end user (customer). Those expenses may include the cost of raw materials, direct labor, and administrative expenses.

    Unlike gross profit, net profit takes into account all expenses, not just the direct costs of producing the goods and, therefore, is the ‘skinny’ profitability measure of what it takes to bring a product to market, not just the direct input costs but also the cost of financing, storing, distributing and marketing those goods and services.

    On one hand, gross profit is a measure of production efficiency, while on the other net profit measures how well costs are being controlled and how good the managers are at getting the market to pay a good price.

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    How to Calculate

    Calculating net profit forms a base for calculating the net profit margin and the net profit ratio. Net profit margin is a measure of what percentage of sales is net profit or how much of each sales dollar is retained as profit.

    Net profit is reported on the “Income and Expense Statement” of financial reports. The formula for calculating net profit is:

    Net Profit = Net sales – Gross Profit – administrative expenses - taxes and interest.

    These figures reveal what percentage of revenue is retained after the all costs are covered. Here is an example; assuming the following: sales are $20,000, cost-of-goods-sold are $7,000 and other expenses (taxes, interest and administrative) total another $7,000.

    The Net profit margin would be:

    Net profit = $20,000 – ($7,000 + $7,000) = $6,000

    Net profit margin = (net profit/ sales) * 100 = ($6,000 / $20,000) * 100 = 30%; which is not a bad figure.

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    Conclusion

    So, now that you know "what is net profit," they are simply a profitability measure derived by subtracting all the costs of operating a business from sales (revenues). It gives an indication as to how well a business is controlling its expenses and extracting a good price for its products and service from the market. Simply put, net profit is the ultimate measure of profitability; it states just how much is left after production and administrative expenses are covered and by extension, how much can be redistributed to investors or reinvested into the business.

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    References

    P. Hosein, "Principles of accounts Heinemann business education for CXC," Heinemann, 1988:P 186

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