Understanding gross income vs net income is a fundamental principle of running a successful business. Stated simply, gross income refers to revenues before you deduct expenses. Net income is your revenue minus costs and expenses.
Differentiating gross income vs net income is crucial if you want to grow your business and maintain healthy profit levels over the long-term. These two figures both represent income, but they tell different stories — both of which relate to your business’s profitability and its ability to secure a small business loan.
Gross income vs net income: Which determines profitability?
Differentiating gross income vs net income is key to driving profitability. Only by understanding when each of the principles applies can you drive your business’s bottom line.
Gross income is a great indicator of your business’s chances of long-term success. This is because it tells banks, loan providers, and investors about your business’s ability to generate sales. If your business — or an individual location — has just opened, gross income speaks to potential. Costs can be cut and controlled over time, but growing sales substantially is usually a more complex undertaking.
What is gross income?
But sales account for only half of a business’s profitability. If you’re running an established business, you’re more likely to be using net income as your main indicator of success. This is because you should already have streamlined operations and cut costs. If you notice a sudden downturn in net income, and your gross income is stable, search for any unexpected, one-off costs that might have hit your business. You should also ascertain whether any fixed costs such as utilities and rent have risen recently.
We’ve outlined gross income vs net income to help you use both financial principles in the correct way.
Gross income is sometimes referred to as gross margin. The term refers to revenue from all sources, minus the cost of goods sold (COGS). If your total sales for the month are $10,000, and you spent $3,000 on the goods or materials to achieve that sales figure, your gross income is $7,000.
Here are two key facts about gross income that should help you manage your business effectively:
- Gross income for individuals should not be confused with gross income for businesses. For the individual, gross income refers to income from all sources, including wages, pensions, dividends, and interest.
- Gross income for businesses refers to gross earnings (total sales) less the cost of selling the goods. However, gross income doesn’t include operating costs such as utilities and rent.
An example of gross income
In most cases, gross income is calculated by taking gross revenue and subtracting cost of goods sold (COGS).
Imagine you sold $1 million of bicycles last year. Your gross income is $1 million, assuming you didn’t sell anything else. But to achieve that $1 million in sales, you had to pay $500,000 for bicycles and parts (cost of goods sold). To calculate gross income, subtract the COGS from the total sales. In this instance, your gross revenue for last year was $500,000.
What is net income?
Net income, also known as net earnings, is calculated by taking your total sales figure and subtracting cost of goods sold (COGS) and all of the operating expenses your business incurs during the course of business. These expenses include:
- Bank fees
- Rents
- Taxes
- Interest
- Depreciation
- Utilities
- Admin expenses
- Selling charges
Once you’ve subtracted operating costs and business expenses from total revenue, you’re left with earnings before tax. Subtract tax from earnings before tax, and you’re left with your business’s net income.
Here are two key facts about net income that should help you manage your business effectively:
- In the US, we calculate earnings per share using net income.
- Net income is used by investors to understand a business’s true profitability. Some unscrupulous business owners hide certain business expenses and inflate revenues. This means that net income should never be taken at face value. Investors should always review the numbers used to calculate the final net income figure.
- Business net income shouldn’t be confused with individual net income. Individual net income refers to earnings after taxes.
An example of net income
You can calculate net income (the bottom line) by subtracting business expenses and tax from your gross income. We already know that your bicycle company achieved a gross income of $500,000 last year. Now, add together all of your business’s expenses, including wages, utilities, rent, service charges, interest, and fixed fees. Let’s say the total figure is $100,000.
Subtract the total expenses from your gross income to work out your profit before tax. Let’s say your taxes amounted to $150,000 for the year. Your net income is $500,000 (gross income) minus $100,000 (expenses/operating costs) minus $150,000 (tax). That’s a total net income for your bicycle business of $250,000.
What is net profit margin?
Net profit margin tells a small business lender or investor by how much sales exceed total expenses (profitability). Put simply, net profit margin refers to the net income as a percentage of total revenue. And this gets to the heart of your business’s viability. Generating sales isn’t enough to persuade a bank to approve small business financing. You need to demonstrate you can control costs and turn that revenue into a healthy net income.
A basic net profit margin formula gives you a quick way of calculating your business’s profitability. Divide your net income (total revenue minus total costs) by your total sales revenue.
How to improve your net profit margin
1.Know your customers
According to a 2008 study by Deloitte, 20 percent of a company’s customer base, on average, produces the highest proportion of profits. What does this mean for your business? Find out who your most profitable customers are — and focus on their needs. How often do they spend? What’s their average transaction value? What products or services do they favor?
2. Assess your products or services
Which products or services are delivering the highest revenues? Are the margins on those products high? If they’re not, you may want to raise prices or find cheaper suppliers. Increasing prices might reduce demand, but it could result in higher revenues overall. Conversely, reducing prices might result in higher sales with a lower margin. Finding out which works best for you overall may involve trial-and-error. Sophisticated forecasting software can also help you to strike the right balance between targeting volume sales and product margins.
3. Streamlining operations
Can you automate some of your processes? Can certain functions or departments be merged? Can you cut the raw materials and supplies you use by changing your processes? Leave no stone unturned in your efforts to reduce unnecessary expenditure.
4. Elevate your brand to increase perceived value among consumers
Why do people pay three or four times more for an Apple laptop than they do for a Google Chromebook? In the eyes of many consumers, the Apple brand alone offers extra value. The prestige of owning a product bearing the famous logo is worth paying for. This kind of brand value can allow you to raise prices without affecting demand.
5. Avoid discounts by monitoring inventory closely
Too many small businesses buy in bulk to cut COGS without forecasting sales. They’re then left with too much cash tied up in stock that’s gathering dust in storage. To liquidate the stock quickly, the business has to discount it — which affects net profit margin in the process.
6. Buy more products/material in bulk
Look for opportunities to buy key products in bulk. You’ll be able to take advantage of economies of scale and reduce the price per unit you’re paying.
7. Develop mutually beneficial relationships with key suppliers
Stay on the best of terms with your most trusted suppliers. Wherever possible, stick to one supplier for each product or material you buy. But make sure you leverage the fact that you’re remaining loyal. With a little goodwill, you might be able to turn this positive relationship into some significant discounts.
8. Train staff to identify upselling opportunities
Train your employees on the intricacies of all your products or services. What are the benefits to your customers? Are there any complementary products? Are there alternatives with higher product margins? Once your employees are armed with this knowledge, they’ll be able to identify opportunities to get more value out of each transaction — through upselling.
9. Monitor and minimize waste/shrinkage
Wastage is a huge problem for food businesses. Foods have a very short shelf-life, so you need to order correctly based on historic sales data and sales projections. When products are close to their expiration date, discount them heavily.
Shrinkage is the loss of inventory. This loss can be caused by shoplifting, employee theft, vendor fraud, administrative errors, or damage. Put in place a strict loss-prevention strategy to minimize shrinkage in your business.
How does gross income vs net income impact business financing?
Understanding gross income vs net income is crucial for accurate small business accounting. The former is a great indicator of war potential, but the latter is what impacts your ability to secure business financing.
Most financial experts view net income as a business’s bottom line — the ultimate indication of profitability. If this figure is positive, and it has been positive historically, the chances of a successful business loan application are relatively high. Lenders will want to know that you have a handle on gross income vs net income.
But net income is just one metric; it’s a number. And numbers don’t always give lenders context. Perhaps your business has turned a corner. Perhaps you’ve just secured a new long-term client. While traditional lenders such as banks tend to look at metrics such as net income when approving secured and unsecured loans, marketplace lenders look for context — and the bigger picture.
Gross income vs net income: The difference is important
As a business owner or key decision-maker, it’s imperative that you differentiate between gross income and net income. You’ll use both figures regularly, depending on the circumstances. If you’re concentrating on sales, the gross figure is most appropriate. Investors look for healthy sales to determine if a business or idea has legs. But if you’re searching for small business financing, be ready to discuss net income in detail.
Loan Solutions OU is here to help you secure the small business loan you need for expansion or consolidation. Provide us with a few details about your business, and we’ll get to work on securing your finance right away.
