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What is Net Profit? – Importance, Formula and Example

Updated on :  

08 min read.

The Net Profit of a company is the amount of money a business earns after deducting interest, operating expenses, and tax over a defined period. Net Profit is also called Profit After Tax (PAT).

Net Profit determines the financial health of the business. It shows if a company makes more money than it spends. When investors want to invest in a business, they check the company’s Net Profit.

How to calculate the Net Profit of a company?

To calculate Net Profit, one must include all company’s financial transactions. 

Net profit = Revenue/Sales + Income from other sources – Cost of Goods Sold – Operating Expenses – Other Expenses – Interest – Depreciation – Taxes. 

The cost of goods sold includes expenses on labour, raw materials, etc. Operating expenses include fixed costs such as rent, advertising expenses, employee salaries, and insurance costs. 

Interest costs are the interest payments the company makes on loans availed. Depreciation is the reduction in the value of the asset over time. Taxes include corporate tax and so on. 

Let’s look at XYZ Ltd.’s Income Statement as of 30th March 2018. 

ParticularsAmount (Rs)
Total RevenueRs 20,00,000
Cost of Goods Sold(5,00,000)
Gross ProfitRs 15,00,000
Operating Expenses
RentRs 50,000
UtilitiesRs 30,000
DepreciationRs 20,000
Total Operating ExpensesRs 1,00,000
InterestRs 30,000
TaxesRs 30,000
Net ProfitRs 13,40,000

Net Profit = Gross Profit – Expenses

Net Profit = Rs 15,00,000 – Rs 1,00,000 – 30,000 -30,000 = Rs 13,40,000.

What is the importance of Net Profit?

Net Profit shows the success of a business. For instance, no matter how much sales a business makes, the Net Profit is what indicates if the company is making money. Net Profit shows business owners how much money is available to invest in the business. 

Banks and lenders look at the Net Profit and decide if they should sanction loans to the company. For example, companies with a higher Net Profit are likely to have strong cash flows and can quickly service interest costs and repay the loans. 

The business owners use Net Profit to compare the business’s profitability across different accounting periods. Net Profit can also be used to compare the performance of companies within the same industry. 

What is the Net Profit Margin?

Net Profit Margin measures the amount of Net Profit generated by a company per rupee of revenue gained. 

Net Profit Margin = Profit After Tax (PAT) / Net Sales

The dues of the shareholders of a business are settled after paying all other stakeholders, which include the government. Hence, shareholders want to know the Net Profit Margin of the company. 

Companies with higher Net Profit Margins are more efficient in handling costs and earning profits. 

Let’s understand Net Profit Margin with an example. Company ABC has a Net Profit of Rs 80 crore and Net Sales of Rs 225 crore. Consequently, Company XYZ has a Net Profit of Rs 30 crore and Net Sales of Rs 100 crore.

Company ABC Income Statement

ParticularsAmount (Rs in Crore)
Total Revenue225
Cost of Goods Sold35
Gross Profit190
Operating Expenses40
Operating Profit150
Interest Expenses10
Profit Before Tax140
Tax Expense60
Net Profit80

Company XYZ Income Statement

ParticularsAmount (Rs in Crore)
Total Revenue100
Cost of Goods Sold20
Gross Profit80
Operating Expenses20
Operating Profit60
Interest Expenses5
Profit Before Tax55
Tax Expense25
Net Profit30

Using the formula one can calculate the net profit margin of Company ABC as 35.55% and Company XYZ as 30%. 

Net profit margin (Company ABC) = Net Profit / Net Sales or 80 / 225 = 35.55%

Net profit margin (Company XYZ) = Net Profit / Net Sales or 30 / 100 = 30%

Hence, Company ABC has a higher net profit margin than Company XYZ.

What is the importance of the Net Profit Margin?

Net Profit Margin shows business owners how much money their company is making. It reveals to business owners how their firm is spending money and helps them optimise profits. 

The Net Profit Margin is different from the Gross Profit Margin. While Net Profit Margin shows the profit accruing from sales, Gross Profit Margin shows company profits on the cost of sales.

For example, Gross Profit Margin shows how various costs such as labour, supplies, and production impact the business’s profitability.

Conclusion:

  • The Net Profit Margin displays the ability of a business to make profits.
  • Companies with high Net Profit Margins can control expenses and have strong pricing power and efficient management.

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