A Guide to Understanding Gross vs Net Income
Every business owner should be able to distinguish between gross and net income. Both measures are important. Gross and net income both show how profitable a company is. Together, they tell different parts of the story.
Let’s compare the operations of a company in a given year to the outcome of a football game.
Gross income, or gross profit, is like the first half of the game. It gives us information on how the company performed until halftime. But this information is partial, and we only know half of the story. Gross profit is the difference between revenue and cost of goods sold. Gross profit tells us how much money we made after considering costs of production only. We don’t know how other expenses affected the firm’s bottom-line profitability. These expenses might include management salaries, office rent, and interest costs.
Net income lets us see the end result. It is like the final outcome of the football game. With net income, we subtract all the business’s expenses from revenues. This tells us whether the firm recorded a net profit or a net loss for the financial year. Yet we need to keep in mind that net income does not give information on the weight of different types of costs. Imagine the only information we have is a company’s net income. We wouldn’t know how much money the firm’s core operations made considering only the cost of goods sold.
Now, put yourself in the shoes of a business manager or a football team coach. Would you want to know the end result only? Or would you want to know how your team (company) did in both the first and second half of the game? In a business context, would you want to only know net income? Or would you also want to know how much margin selling the firm’s products made?
Of course, you would want to see both parts of the income statement. This is why companies calculate both gross and net income for a business.
Calculating gross profit margin
People often calculate different profitability ratios based on the income statement. Unsurprisingly, the two major ratios are gross profit margin and net profit margin.
Gross profit margin is also known as return on sales. You calculate it by totaling revenue minus costs of goods sold and dividing by revenue.
Similarly, the net profit margin equals net income divided by revenue.
We can work out any sub-total in the income statement as a percentage of the total revenue. Companies often estimate an operating profit margin or a pre-tax margin. These are very important formulas to remember. What’s more important is the ability to understand the results.
Let’s use Shell’s income statement to calculate some profitability measures. First, we look at everything above the net income line. We want to calculate the gross profit and net profit margin ratios for the current year, or Year 3 in our example. How would we do that?
Gross profit margin equals a gross profit of $75,187 million divided by total revenue of $396,556 million. This makes 19% in the current accounting period and 20% in the previous two years. It seems that the company was less profitable in the last year. Why might that be?
There are two possible reasons for a gross profit to decline. Either revenue decreases or the cost of goods sold (COGS) increases. We need to move to a common-size income statement to understand why. Let’s do it!
Let’s represent each line item as a percentage of total revenue. We will see that the cost of goods sold was 81% in Year 3. This is 1% higher than Year 2’s figure, so it explains the difference.
So how can a company improve its gross profit margin? A company can raise its prices and sales volume or lower its production costs. Either one would do the trick!
Calculating net profit margin
The net profit margin comes next. To get it, we need to divide net income by total revenue. This gives us 6%, 4%, and 2% respectively.
Compared to the gross profit margin, the net profit margin rose a lot over the years. That is interesting! Let’s look at why.
Looking at Shell’s common-size income statement again, we see that the operating profit of the company is 10% of its total revenue in year three. That is much higher than in the previous two years. This is because of the lower depreciation and amortization costs in the current accounting period. It looks like the company bought some long-lived assets a few years ago. Then they applied an accelerated depreciation method. In year three, the company gains from recognizing depreciation expenses earlier in assets’ useful life.
By the way, did you notice that we don’t have to calculate gross profit margin and net profit margins separately? So long as we have a common-size income statement in place, the gross profit and net income lines figure out the ratios automatically.
Shell’s net profit margin has been improving in the last three years., Still, is 10% good enough? To decide, financial analysts compare these results to the industry average. You might want to check the average net profit margin of the company’s major competitors. If it is 15%, this means that Shell has a lot of work to do in optimizing its revenue and expenses to catch up to its rivals.
Coming to conclusions with gross vs net income
The difference between gross and net income is clear. Gross profit (income) indicates how much money a firm made by selling its products. Gross profit only takes into account the cost of production. Net income tells us how much money the company made after you consider all types of costs.
What is more subtle is how to understand each of these types of measures. You can use the gross margin and net income margin ratios to make conclusions about a given business. Then you can make a plan of action depending on what you learn looking at both gross income and net income.
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