Understanding Your Bottom Line: Gross Profit vs Net Income
As a small business owner or startup founder, you’re going to come across different measures of profitability when looking at your company’s income statements. Two of the most important measures to look at are gross profit and net income. Confusing gross profit with net income or vice versa can skew your view of your company’s financial health. Understanding what each of them signifies, on the other hand, enables you to make the right decisions for your business based on facts, not fantasies.
Defining gross profit
A company’s gross profit, sometimes known as gross income, is a term used to signify your company's total earnings through the sale of goods or services. It shows whether or not you're able to bring in revenue from your product after the costs to make it are taken into account. Gross profit is calculated using the following formula:
COGS, or cost of goods sold, refers to the costs associated with producing the goods or services your business is offering. These include things like raw materials, labor costs, and packaging. Gross profit is an important metric, as it’s a good way to understand whether or not your current pricing and purchasing strategies are viable for your business. It helps businesses calculate how much to charge for a product or service. This is particularly important for young businesses. Monitoring gross profit of the total sales of a product over time also gives you insight into emerging trends in the industry. Being aware of these trends puts you in a position to adapt and remain profitable. If you’re looking to increase your gross profit margins, you can do so by:
- Increasing the price of your goods or services
- Reducing your direct costs by buying supplies and raw materials in bulk
- Improving the efficiency of your operation by investing in R&D or G&A
Defining net income
Net income takes the total amount of your operating expenses into account and gives you a picture of your overall profitability as an operation. It’s calculated using the following formula:
Total expenses in the formula refer to all of your business expenses:
- Sales and marketing costs (S&M)
- General and administrative expenses (G&A)
- Research and development (R&D)
- Business overhead costs
Net income is, therefore, a clearer indicator of company profit than gross profit since it takes all expenses into account. It’s what gives you the clearest picture of your bottom line and is the best measure of profitability. By tracking net profit and not just gross profit, owners can measure profitability rather than just the amount of income or total sales. It’s also important, particularly for small business owners, as it can guide owners towards making their business profitable by either increasing sales or by cutting expenses. If you’re looking to increase your net profit margins, you can do so by:
- Improving your gross margins
- Cutting back on cost centers that produce little direct ROI, such as some R&D or high-overhead expenses like office space
Why gross profit margins don’t tell the whole story
What JCPenney teaches us about gross margins
In late 2020, retail store chain JCPenney filed for bankruptcy after years of financial struggle. This came as a surprise to some since a look at their income statements from 2017 and 2020 shows the company reported positive gross profit. In 2017, the corporation reported net sales of $12.5 billion and gross profit of $4.33 billion. Their net income, however, was a $116 million loss. In Q3 of 2020, JCPenney reported a gross profit of $580 million. Once again, they posted a net loss of $368 million. JCPenney is a clear example of how expenses like rising indirect costs, debt, and interest can lead to net loss despite reporting gross profits. It shows that looking at gross profit alone does not give you a clear picture of a business's financial health.
Why SaaS companies typically have higher gross margins
SaaS companies tend to be valued higher than their non-software counterparts. While both are recurring revenue businesses, SaaS is normally valued at over 10x revenue when compared to just 4x EBITDA for non-software companies. This is because SaaS companies tend to have significantly lower overhead. The creation and distribution of a digital product don’t require any form of manufacturing, raw materials, or large production centers to run. SaaS gross margins are typically higher than 80%, while non-software company margins are typically anywhere between 20 and 30%. A higher gross margin in these cases means a significantly higher enterprise value. The business communications platform Slack was valued at a high 10x+ revenue multiple when they were bought by Salesforce in July of 2021. Law firms, on the other hand, tend to have much lower gross margins, so they’re valued as a multiple of EBITDA.
Avoid common mistakes when analyzing financial statements
Even though it’s the clearest indicator of a company’s bottom line, net income also has its own limitations. When a company sells a fixed asset like a piece of property, that is also included as an income source and would increase the organization’s net income in that accounting period. This could be problematic for investors looking at your net income without having all of the information on the different types of profit you’re reporting. The sales revenue you’ve made on the sale of that asset is likely not of interest to them, and it might lead them to misinterpret the company’s overall profitability.
Stay on top of your finances with accurate bookkeeping and financial projection software
With so many different measures of profitability and other variables, there’s a lot of room for error and misunderstanding in your company’s financial reporting. Pry offers reliable and accurate bookkeeping and financial projection solutions that make it easy for you to keep track of your business’s profitability metrics, such as gross profit and net income. Pry allows you to carry out your accounting, financial planning, and business intelligence all in one place.
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