The truth about the net profit formula

Revolut Contributor

 · 06/24/2020  · 06/24/2020

The net profit formula is the revenue of a business over a given period once it deducts all the costs of providing its goods or services. Put simply; it’s the total revenue minus total costs. However, this description has some nuances for two crucial reasons, which we explore here.

Why is the formula for net profit confusing?

First, people tend to group these costs into different types of categories, and this can make the formula seem complicated. Some costs (e.g. wages) are obvious, others are less so. Examples include the depreciation of long-term assets or interest owed on loans.

This idea brings us to the second point: whether or not the figure shown for the net profits of a business includes a deduction for the tax due. Sadly, the correct answer isn’t clear-cut.

In the UK, there is ambiguity around the concept of “net profit” because it is not defined by the Financial Reporting Standard (i.e. FRS102). Even so, this idea is generally understood to mean the business profits for a given period after all expenses, including tax. This is the same as the US, where it’s the final figure on an income statement.

For UK businesses, this grey area means the phrase “net profit” sometimes refers to profit before tax is removed – or even a different profit metric, such as EBIT. Check carefully.

What is the net profit formula?

When you consider how to calculate net profit, the place to begin is with the basic formula, which is revenue minus total costs. In reality, people break-up costs into categories and the most common ones are direct or indirect. As the names suggest, direct costs are related to sales (e.g. raw materials), and indirect ones are unrelated, or fixed, overheads such as rent.

Net profit = Revenue – Direct costs – Indirect costs

Once you deduct the indirect costs of a business from its revenue, you arrive at the gross profit. And this is how the second definition of net profit formula suddenly appears.

Net profit = Gross profit – Indirect costs

What doesn’t help is that people routinely use different words to describe the same ideas. For instance, revenue might well be called sales or turnover, and direct costs are often known as the cost of goods sold (COGS). Learn more about net profit.

Another way to look at the net profit formula is to split indirect costs into three chunks. Here, the day-to-day running costs, which include depreciation, are separated from interest or tax due. We dive into this in the operating profit formula post. What matters is that net profit is the amount of money left after you deduct all costs, so it’s good to see these clearly.

Net profit = Gross Profit – Operating Expenses – Interest – Tax

Is net profit the most valuable profit metric?

Business owners and investors view net profit as a reliable indicator of financial health, and it’s also an obligatory aspect of calculating the tax position. The figure is easily converted into net profit margin to track the business performance over a period of time.

The comprehensive nature of net profit certainly makes it an insightful metric, but it has issues. To begin with, the ambiguity mentioned above makes this a trickier idea for UK businesses than, say, EBIT or EBITDA, even though it’s easier for non-finance pros to grasp. It’s also worth noting that net profit does not reveal the cash position of a business.

The catch-all status of net profit with regard to total expenses can make it a blunt instrument compared to more nuanced metrics, which exclude specific types of costs. For instance, operating profit is closely watched on financial statements, as it focuses on the issues considered to be more within the control of managers than the interest owed or tax due.

With smaller companies, whose accounts lack complexity – for example, depreciation or financing arrangements – the differences between some of these metrics can be academic. That said, it’s wise to know what they mean so you don’t compare apples with oranges.

Sign up in minutes