What is net profit?

How is net profit worked out?

Start with sales. Take off the direct cost of making those sales — materials, stock, subcontractors — to get gross profit. Then take off the overheads: rent, insurance, wages, software, the accountant, vehicle costs, everything the business spends to exist. What is left is net profit before tax. Take off the tax and it is net profit after tax.

The figure that matters depends on who is asking. HMRC starts from net profit before tax, adjusted for things it does not allow, to work out the tax. A lender wants to see it covers loan repayments with room to spare. An owner wants to know what can be taken out without hollowing out the business.

One thing it is not is a cash figure. Net profit includes sales invoiced but not yet paid and excludes money spent on assets that will be depreciated over years. A profitable business can run out of cash, and a business with cash in the bank can be making a loss.

A worked example

A café takes £18,000 in a month. Ingredients, milk, coffee and packaging cost £6,500, so gross profit is £11,500 and gross margin is about 64%.

Overheads for the month are rent £2,000, staff wages £5,000, utilities £600 and everything else — card fees, insurance, cleaning, software — £900, so £8,500 in total. Net profit before tax is £11,500 less £8,500, so £3,000: a net margin of just under 17%.

The owner has not yet paid herself. If she is a sole trader, that £3,000 is her income for the month and she pays tax on it through Self Assessment. If the café is a limited company and she draws a £2,000 salary, that salary is an overhead, the company's net profit is £1,000, and corporation tax is charged on that.

Why does net profit differ from the bank balance?

• —Sales invoiced but not yet paid count as profit but are not in the bank.
• —Bills received but not yet paid reduce profit but are still in the bank.
• —Buying a £9,000 van barely dents profit, because it is depreciated over years, but empties the bank at once.
• —VAT collected sits in the bank but is not income; VAT paid to HMRC leaves the bank but is not a cost.
• —Loan repayments reduce the bank but not profit; only the interest is a cost.
• —Drawings by a sole trader or dividends to a shareholder come out of the bank after profit has been measured.