As a business owner, you probably have an idea of what your gross profit is. But do you know what that number means in relation to the overall health of your business?
The term “gross profit” is often used interchangeably with “net profit” and many business owners don’t realize there are actually some significant differences between them. Although both terms refer to profitability, they measure different things about your business.
In this post, we cover the difference between gross and net profit, as well as why it matters to measure both when looking at profitability.
What is gross profit?
Gross profit, sometimes called gross income or gross margin, is defined as the difference between sales revenue and the cost of goods sold. It's a pure number that doesn't account for any other costs in your company's operations.
What is net profit?
Net profit is the amount of money left in a company after all expenses have been paid. It's calculated by subtracting a company's total costs from its total revenue.
Gross profit vs. net profit
Gross profit is the difference between sales and cost of goods sold, while net profit is the difference between sales and total expenses.
Gross profit is calculated by taking your revenue minus your cost of goods sold. In other words, it’s the profit before you pay for any expenses or taxes. Net profit, on the other hand, is what’s left over after everything else has been paid for including operating costs like wages and rent.
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How to calculate the gross profit margin
Gross profit is calculated by taking the net sales and deducting all costs. Then, you divide that number by sales to arrive at gross profit margin.
Net Sales - Cost of Goods Sold = Gross Profit
Gross Profit / Net Sales = Gross Profit Margin
How to calculate the net profit margin
The net profit margin is the ratio of your company's net income to its net sales.
To calculate the net profit margin, you'll need to know the following:
- Net sales (or revenue)
- Net income
Net income is calculated by subtracting the cost of goods sold from your revenue. The cost of goods sold is equal to beginning inventory plus purchases minus ending inventory.
Net sales is calculated by subtracting your beginning inventory from your ending inventory.
To calculate net profit margin, first determine your company's net income. Then divide that number by your total revenue to find its percentage of profitability.
Net income / Net Sales = Net Profit Margin
The impact of gross and net profit on your business
Gross and net profit are two separate figures that measure profitability, but they also work together to create several key metrics that can be used to track the financial health of your business.
Gross profit is the total revenue you bring in minus all costs associated with the production and sale of your products, while net income is that gross profit minus all expenses, including taxes and employee salaries.
To calculate your business's profitability metrics like ROI (return on investment), it's important to have both figures available since they measure profitability from different angles. As such, understanding each figure separately as well as how they can be used together will help you make smarter decisions about growing your business.
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Earnings before interest, taxes, depreciation, and amortization (EBITDA)
Earnings before interest, taxes, depreciation, and amortization (EBITDA) is a financial metric used by companies to evaluate their performance. It's similar to gross profit in that it measures how much money you're making before paying off interest on your loans or other expenses like rent and advertising. But unlike gross profit, which only accounts for costs of goods sold (COGS), EBITDA includes all sorts of overhead expenses like payroll and marketing.
This means that if you have a high EBITDA number for your business—especially compared to others in the same industry—it could be because you're spending more money on salaries than other agencies. Or perhaps you don't have any debt on your books at all. Either way, an agency owner should look at this number when evaluating their profitability as it offers insight into how efficiently the agency is being run overall.
EBITDA is the primary number used by banks to look at the health of a business. Banks will use this figure when looking to approve loans and mortgages, as well as when valuing the size of an agency. EBITDA can cut through some of the "one-time" non-operating expenses, such as depreciation on a vehicle, to understand the true health of the business' operations.
In the end, what matters most is understanding your business and its profitability. That way you can make better decisions about where to spend your time, money and energy.
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