Whether you are a small business or self employed, it’s vital for the health and security of your business to know how much profit you make. Knowing this figure can inform current and future strategy, forecast growth, and help to obtain investment.
You can use profit to invest in new technology or development, pay dividends, and use it to work out your margins, gauging the health of your business against other companies in your industry. You also need to know your net profit to pay tax, which differs depending on which tax bracket you are in.
There are different types of profit, which we will cover later on this guide, but net profit essentially gives you the ‘real’ profit of your business. It is the measure of success of a business, and is one of the figures banks and potential investors would look at to assess the suitability of providing a loan or investment.
There are lots of different terminologies when it comes to accounting, and you may see net profit referred to as before tax and after tax. In this article we’ll break down what this means, as well as what net profit is, how to calculate it and why it is important.
IS NET PROFIT BEFORE OR AFTER TAX?
Depending on how you choose to show profit and loss on your financial statement, net profit can either be before tax or after tax. Net profit is the amount of money a business has left from its revenue after it has deducted the cost of materials, expenses… and usually taxes.
However, some businesses may choose to show net profit as a figure before tax, or have two separate entries: before tax and after tax. We’ll explain further on this guide why you might want to do that. There isn’t a right or wrong way of doing it, as long as you know what you are referring to by net profit, how to calculate it, and, most importantly, that you are paying the correct amount of tax.
WHY SHOW NET PROFIT AS BEFORE TAX AND AFTER TAX?
Whilst the figures for net profit before tax and net profit after tax follow a similar methodology to calculate (the difference being that one has an extra step that deducts all tax owed), they can be used by a business in different ways.
Net profit before tax is really an indicator of operating performance. By excluding the tax that is owed, it removes another variable to be able to drill down further and look at operating procedures. It also gives business owners and investors the option to compare their company to other companies operating under different tax laws.
If a business is in an industry that benefits from favourable tax laws, showing net profit before tax provides a more like for like comparison.
Net profit after tax is what we sometimes hear referred to as the “bottom line”. It is the amount of revenue left after all costs have been deducted.
If you are a sole trader or business owner doing your own accounts, highlighting the difference between the two might not be something you’ve thought about. Most of the time you will be aware of what the correct figure is but there are times when knowing both will be really useful.
For sole traders or company directors, mortgage companies often require your net profit before tax or net profit after tax to assess your suitability for mortgage repayments. Providing your after tax figure, when they have have requested your profit before tax, could have a major impact on your application in terms of how much they are willing to let you borrow.
For potential investors, analysing pre-tax profit is a valuable way of gauging the efficiency of a business. Having this figure readily available can provide an extra insight into your business.
HOW TO CALCULATE NET PROFIT?
In business accounting there are two main types of profit: gross profit and net profit. It’s important not to confuse the two. If you do, it could have serious consequences and lead to a much bigger tax bill than you anticipated! Let’s take a look at what the difference are and how you calculate them.
WHAT IS GROSS PROFIT?
Gross profit is the difference between the total revenue (income) generated by a business and the cost of goods sold (COGS).
COGS are the direct costs associated with making a product, such as the cost of buying material and direct labour costs.
For example, We’ve Got Sole is a company that makes shoes. Their cost of goods are the raw materials for making the shoes and the cost of paying a worker to make them.
Gross profit does not factor in indirect costs, such as the rent on a building, office operating costs, or indirect wages of other staff (e.g. receptionist or administrator who are not directly involved in making the goods).
Gross profit is really useful for a business to keep track of how they are managing their material and labour costs. If these costs are too high then it will have a big impact on the overall profit.
WHAT IS NET PROFIT?
Once you know your gross profit you can work out what your net profit is. In simple terms, net profit is the amount you have remaining from your revenue after you deduct all of your total costs. Unlike gross profit, where you deduct only the cost of goods sold, to calculate net profit you need deduct all allowable expenses. These include things like office rent, advertising, salaries, National Insurance…and usually tax.
As we explained earlier, on your profit and loss statement you can show net profit as either before or after tax (you may also see references to operating profit which is essentially net profit before tax). For the purpose of this example we will include the deduction of taxes in our net profit calculation.
Let’s look at our We’ve Got Sole example from earlier. This company’s revenue for the year is £1,500,000 and the cost of goods sold is £500,000, giving them a gross profit of £1,000,000.
This amount isn’t the ‘true’ profit though, as they have other expenses on top of purchasing the raw materials and labour costs. They run a factory, pay operating costs for heating and lighting, pay employee wages, including National Insurance contributions and taxes.
The total cost of all of these expenses is £400,000, which gives We’ve Got Sole a net profit of £600,000.
WORKING OUT YOUR PROFIT MARGIN
Profit margins are really useful for business owners who want to check the health of their business and set future targets.
To work out your gross profit margin you simply divide your gross profit by revenue. For We’ve Got Sole, this will be:
£1,000,000 ÷ £1,500,000 = gross profit margin of 66.67%
To work out you net profit margin you simply divide your net profit by your revenue.
£600,000 ÷ £1,500,000 = 40%
WHAT TAX DO I HAVE TO PAY?
After you calculate your gross profit, you then need to deduct allowable expenses and tax. The taxes you pay depends on how your business is registered and your company is structured. This means the tax a sole trader has to pay is different from a limited company.
Let’s take a closer look at what might apply to you.
Corporation tax is applicable to limited companies and is calculated on the profit after all allowable business expenses are deducted (for ease of explanation we’ll call this net profit before tax). The rate of tax you need to pay is 19% and it must be paid on all profits.
To do this a business needs to submit a company tax return to HMRC, and your bill is payable nine months and one day after the end of your accounting period.
It’s vital you are calculating against your net profit before tax and not your gross profit otherwise you could end up with a much bigger bill!
You only have to pay income tax if you are an individual. Business owners don’t have to pay any income tax relating to the business itself. If you are an employee then your tax will be paid through PAYE, which will be calculated and taken by your employer, along with National Insurance, before they pay your wages.
If you are sole trader you pay Income Tax on your business’s taxable profits (the profit after costs of goods and allowable expenses are deducted). In order to calculate how much tax you owe, you need to deduct your tax-free Personal Allowance from your profit.
NATIONAL INSURANCE CONTRIBUTIONS (NIC’S)
If you are a sole trader you must also pay Class 2 NIC’s of £3.05 per week if your profit is more than £6,515, and Class 4 NIC’s if your profits are more than £9,568. There are two thresholds for Class 4 contributions with a rate of 9% payable of profits between £9,568 and £50,270 and 2% payable on profits over £50,270.
WHY DO I NEED TO KNOW MY NET PROFIT?
Your net profit is important! It helps you work out if you are generating enough profit from your sales and that your operating costs are under control. It’s a bit like getting a check-up at the doctor and being given the okay. Your net profit is an indicator of how healthy your business is.
It’s also something that you should know. It avoids you using the wrong figures, which can have serious consequences if you get your gross profit and net profit mixed up when paying tax!
You’ve likely seen some poor soul on Dragon’s Den try and answer a simple question about the financial state of their business and end up wishing the ground would swallow them up as they get more and more confused. We hope this guide helps you avoid a situation like that ever happening to you.