How to calculate net profit

business.gov.au's glossary describes net profit as gross profit with all business expenses taken off, and gives the bottom line as another name for it. Its profit and loss statement template reaches the same figure by taking expenses away from sales.

Written out in full: start with sales, take away the cost of goods sold to reach gross profit, take away operating expenses such as rent and wages, then add any other income, such as interest received, and take away other expenses, such as interest paid on a loan. If the answer is below zero, the business made a net loss for the period.

Gross profit is what's left after the direct costs of what you sold; net profit is what's left once running costs, interest and every other expense have come off too. business.gov.au's glossary defines gross profit as the difference between sales and the direct cost of making those sales, and net profit as gross profit less all business expenses.

Each answers a different question. Gross profit tells you whether your prices cover what each sale costs you to make or buy. Net profit tells you whether the business as a whole earns more than its expenses once rent, staff, insurance, interest and everything else is counted. In the design studio month below, gross profit was 22,300.00 but net profit only 7,605.00: most of the gross profit went on running costs. A business can have a healthy gross profit and still make a net loss if its overheads are too heavy for its sales.

Watch the labels. The same glossary lists turnover as another name for revenue, the amount earned before expenses. So turnover is the top line of the statement, not net profit. When a report or a lender uses a term like this, check which line they mean.

business.gov.au notes that a profit and loss statement normally covers a month, a quarter or a year. Pick the period, then make sure the books for it are complete before you add anything up:

• reconcile every bank and card account up to the period's final day
• record all sales invoices and supplier bills belonging to the period
• on accrual books, look for costs the business has run up but not yet been billed for, such as power used to the end of the month; check with your accountant how to record them, and label any estimate clearly, as business.gov.au asks
• use each account's activity for the period's own dates, not a year-to-date balance.

Plenty of money leaves the business account without being a business expense. Including it understates net profit, sometimes by a lot. These usually stay out of the calculation:

• Drawings by a sole trader or partner: business.gov.au's glossary describes drawings as personal expenses paid from a business account.
• The part of each loan repayment that pays the loan down. Only the interest part is an expense.
• Equipment, vehicles and other larger purchases, which are generally recorded as assets. How they are treated in the accounts is a question for your accountant.
• Repayments of a business credit card, where each purchase on the card was already recorded when it was made.
• Transfers between the business's own accounts.

Money coming in can be misleading too. A new loan, or money an owner puts in, raises the bank balance but isn't income, so it doesn't add to net profit.

During the same month the sole trader also took drawings for personal use and paid down part of the loan. Neither appears in the table, because neither is a business expense. Both still reduced the bank balance, which is one reason it rarely moves by the same amount as net profit.

Divide net profit by sales for the same period. The result comes out as a decimal; a report that shows it as a percentage has simply multiplied it by 100. Net profit ratio and net profit percentage are other names for the same calculation.

Margin makes periods of different sizes comparable. A bigger quarter will usually produce a bigger profit, so the useful question is whether each dollar of sales kept as much as it did before.

Last year, 15,400.00 divided by 96,000.00 gives 0.16. This year, 12,700.00 divided by 104,000.00 gives 0.12. Sales grew by 8,000.00, yet net profit fell by 2,700.00, and the margin shows how much ground was lost: each dollar of sales kept about 16 cents of net profit last year and about 12 cents this year.

Working back up the table shows where it went. Paper, ink and finishing rose by 6,300.00 on 8,000.00 more sales, so gross profit barely moved, and operating expenses grew by 4,600.00 on top. A negative margin means a net loss for the period. The margin could only go above 1.00 if other income, such as interest received, were larger than all the costs put together, which would be unusual for a trading business.

Compare your margin with the same period last year, the months either side of it, and the margin your budget assumed. A margin figure from other businesses is a rougher guide to your own, because costs, prices and the way owners are paid differ from one business to the next.

For a sole trader or a partnership, what the owners take out is usually drawings rather than wages, so net profit is worked out before any owner's pay. The figure has to stretch to cover what the owners live on. In a company, wages paid to the people who work in it are generally an expense. How any payment to an owner is recorded depends on the business structure and what has been agreed, so check with your accountant.

business.gov.au counts being unable to pay yourself a salary out of the business among the signs of poor profitability.

• The result should agree with the bottom line of the profit and loss statement for the same dates.
• Scan recurring bills such as rent and subscriptions for a missing month or a double entry.
• Compare it with the same period last year and look into any line that has moved sharply.
• Look for anything parked in a suspense or uncategorised account, which can hide an expense or a sale.

Then put it next to the cash flow statement. business.gov.au describes that statement as following the cash a business generated over a period. A healthy net profit and a falling bank balance can sit side by side, for example when customers are slow to pay.

Not from one balance sheet, because it shows a single date and net profit belongs to a period. Two balance sheets, one at each end of the period, give you a useful check figure.

business.gov.au's glossary describes net assets as total assets minus total liabilities, also known as owner's equity. Net assets change over a period for three main reasons: the profit or loss, money the owners put in, and money they take out. Rearranged, net profit equals closing net assets minus opening net assets, plus what the owners took out, minus what they put in.

Treat the result as a cross-check, not a replacement for the profit and loss statement. If the two don't agree when the owners' money in and out is counted from the bank statements, something has been recorded in the wrong place, for example a payment to the owner coded as an expense, or the other way round. The check also assumes nothing else changed equity, such as a revaluation your accountant has recorded.

Beyond payments that aren't expenses, a few timing and coding errors push net profit up in one period and down in another. Each leaves a trail you can spot.

• A yearly bill charged to one month. Insurance or a licence paid once a year makes that month look poor and the other 11 look better than they were. Spot it: one month's expenses jump for a cost that covers the whole year. Fix it: judge the year as a whole, or on accrual books ask your accountant whether to spread the cost over the months it covers.
• Customer deposits counted as sales. On accrual books, a deposit for work not yet done is generally money the business owes the customer until the work is delivered. Spot it: sales jump in a month when little work was finished. Fix it: keep a list of deposits held, and check with your accountant how to record them.
• Every stock purchase treated as a cost of the month it arrived. For a business that holds stock, cost of goods sold is the cost of what was sold, not of what was bought. Spot it: profit dips in months with a big delivery and recovers in months without one. Fix it: count stock at the end of the period, ask your accountant how to value it, and work out cost of goods sold as opening stock plus purchases less closing stock.
• Business costs paid personally and never recorded. A business bill paid with the owner's own card is still a business expense. Spot it: a supplier you know you used has no bill in the period. Fix it: record the expense with a note of how it was paid, and ask your accountant how to record the owner's side.

Work back up the statement to find where the gap opened. Has gross profit fallen, or have running costs grown? business.gov.au names costs rising while profits don't, and relying on borrowed money to keep operating, among the signs of poor profitability.

A loss reads more clearly next to the balance sheet, cash flow statement and budget, the documents business.gov.au's yearly financial health check also covers. If the losses continue, raise them with your accountant or a business adviser early.

By selling more, keeping more gross profit from each sale, spending less on running the business, or a mix of these. The statement shows which lines to work on, and the next period's figures show whether a change worked.

On the sales side, business.gov.au suggests offering something new, expanding your market or improving the way you sell. On the gross profit side, it suggests knowing what each product or service costs to produce, working out the margin you need to cover your costs, and seeing whether prices can rise without losing business. It also suggests focusing on your most profitable customers, products or services.

On the cost side, it suggests reviewing costs regularly, dropping those you can do without, and shopping around or switching suppliers, banks or insurers where that saves money. Its budgeting guide adds a simple test for when spending runs high: spend only on what is essential to running the business, and look for cheaper ways to get the essentials.

Change one or two things at a time and note what you changed, so the next statement shows the effect of each.