When you think about how to calculate net profit, it can feel daunting. In reality, the net profit formula is simple: it's the total revenue of a business over a given period, once it deducts all the costs of providing its goods or services. However, there are a few nuances that are helpful to understand.
Net profit = Revenue – Total costs
What does net profit mean for a UK business?
Before we cover the practicalities of how to work out net profit, it's wise to note the ambiguity around this idea in the UK. The term has no statutory definition here, and is not outlined in the UK's Generally Accepted Accounting Practice (GAAP) guidelines (i.e. FRS102).
In the UK, this concept can either refer to the profit a business makes after its total expenses but before it deducts the tax bill; or it can describe the profit for the same period after the tax bill gets removed. In other words, it represents the profit either before or after the taxman takes a slice.
Generally speaking, net profit is understood to mean profit for the period once you remove all costs (i.e. post-tax). This approach is the same as the US, where it's the bottom line on income statements. When you discuss net profit in the UK, check which version is wanted so you perform the appropriate calculation.
What is the net profit formula?
The formula outlined above is straight forward enough, and yet it is often expressed with different words to explain similar ideas. For instance, revenue is sometimes called total sales or turnover. While there are a few subtle differences between these terms they are rarely significant. The main principle is universality: to calculate net profits, you include all income streams within revenue.
Another way to show how to work out net profit is to take the figure for gross profit and deduct the indirect costs. As the name suggests, indirect costs are the expenses unrelated to sales activity. These include basic overheads – for instance, rent or utilities – along with some less obvious costs such as interest on loans, or the amounts shown in the accounts for the depreciation of fixed assets.
Net profit = Gross profit – Indirect costs
How to work out net profit margin?
Net profit has a monetary value, but the net profit margin is a ratio. The latter reveals how much net profit the business makes for each pound that it generates over the same period. The method to do this is below. You need to multiply the answer by one hundred to convert the ratio to a percentage.
Net Profit Margin (%) = (Net Profit / Revenue) x 100
What other real-world criteria affect this calculation?
Perhaps the biggest issue is timeframe. To gather all of the figures you require for the net profit equation, you must grasp how each one relates to the specific period.
The first step is to allocate the correct amounts of revenue that the business generated from selling its goods or services into the relevant month or year. We cover the principle of revenue recognition in detail here. After this, you must complete a similar process for the expenses. Hours of fun.
You will also need to know if the business has any other income for the period and the interest it owes on loans. Then, there are the amounts shown in the accounts to reflect the declining value of long-term assets, such as machinery or patents (i.e. depreciation or amortisation). Remember, the business does have discretion here. For instance, the number of years over which it depreciates the economic benefits of these items.
Finally, there are the taxes due – assuming that these are part of the calculation. Once you have the correct figures, it's easy to deduct all these costs from the total revenue for the same period to reveal the net profit. For added joy, this figure is also known as the net income, but that's another story.Sign up in minutes