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Understanding Bookkeeping Talk: Profit
by Wendy Priesnitz
Q: What is the difference between gross profit, net profit, and operating profit for a small business? And what are profit ratios?
A: The difference among the three ways of expressing profit involves different categories of expenses. Gross profit is net sales minus the costs of goods sold. Operating profit is gross margin minus selling and administrative expenses (all expenses except income tax). Net profit is operating profit minus any additional expenses and taxes.
By examining these numbers on your business statements, you will get a true picture of your company's performance. For instance, you might learn that in spite of strong revenues and what seems like a positive cash flow, what you thought was a profitable business is really showing a net loss due to high overhead expenses.
The three ways of expressing profit can each be used to construct what are known as profitability ratios. This is done by dividing each item by net sales and multiplying by 100 to create a percentage, which also can be expressed as a ratio.
Expressing the numbers this way makes it easy to compare your company's financial results at different time periods. It also allows you to compare your results with those of other companies and with industry benchmark ratios.
For instance, if your gross profit margin (gross profit divided by net sales multiplied by 100) is lower than the average for your industry, or has declined from last quarter, it may mean your markup is too low or you are paying too much for your merchandise.
Examining your net profit margin (net profit divided by net sales multiplied by 100) can help you decide among other things - if you can increase or should decrease the size of draw you're taking from your fledgling small business.
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