Understanding the financial basics of how to differentiate your business’s revenue from its profit.
Every budding business owner and excitable entrepreneur wants their company to get off on the right foot. But to do so, you will need to know some of the financial basics.
Two of the most important financial terms you’ll want to master early are revenue and profit. Often used interchangeably, they actually refer to totally different aspects of your income statement, and you’ll need to know their ins and outs come tax time.
Let’s dive into how to differentiate the two, as well as some helpful formulas every business owner needs to know.
Revenue versus profit: what's the difference?
Revenue refers to the income a company generates before you subtract expenses. There are two main types of income — operating revenue and non-operating income.
Operating revenue is generated by the sale of a business’s primary activity. For example, a retailer earns operating income by selling goods, whereas a builder earns operating income by providing a service.
Non-operating income is money received from sources unrelated to the primary activity of the business. For example, the sale of business assets is classed as non-operating income.
Profit, however, is the value of this revenue once you deduct any expenses. If this value is a positive number, your business is said to have earned a profit. However, if the value is negative, the business is said to have suffered a loss.
There are three types to be aware of: gross, operating and net.
Gross profit is the value that remains after you subtract the cost of goods sold (COGS) from revenue.
Operating profit, or Earnings Before Interest and Tax (EBIT), is the value you calculate after deducting all operating expenses — such as commercial rent, employee income, sales and marketing costs etc. — but before deducting interest and tax.
Net profit is the value that remains after you deduct all expenses from your gross profit or revenue — including interest, tax and non-cash elements like depreciation of fixed assets.
Learning how to differentiate the terms is crucial in understanding the financial health of your business.
Revenue versus Profit: what formulas do I need to know?
There is a range of important formulas that you’ll need to familiarise yourself with when analysing your income statement. Mastering the following formulas will help you better understand the successes and weaknesses of your business.
One of the easiest ways to calculate your total amount of sales, it determines the total income generated from the sale of goods and services. All you need to do is multiply the number of units sold by the cost per unit.
Gross revenue = number of units sold x cost per unit
For example, your business sells 1,500 units of your first product at a price of $29 per unit over a set period. The gross revenue (also called gross income) would be $43,500.
While the above formula may paint a rosy picture of your business, you still need to know just how much your expenses are eating into your income — this is where gross profit comes in handy. It is calculated by subtracting the cost of goods sold (COGS) from your revenue — including raw materials, labour, shipping costs and more.
Gross profit = Revenue - COGS
But it’s not enough to just subtract the COGS from your revenue. As a business owner, you know that your operating expenses — such as inventory costs and marketing — eat into your bottom line. Understanding this formula can help you identify any areas where you could cut down costs to boost your bottom line.
To calculate this, you subtract the COGS, operating expenses, depreciation expenses and amortisation expenses (cost of “intangible assets” like a patent) from your revenue.
Operating Profit = Revenue - COGS – operating expenses – depreciation expenses – amortisation expenses
= Net Profit + interest expenses + taxes
As mentioned above, this is the total value you’re left with after you subtract all expenses from your revenue. This helps you understand your company’s overall efficiency better and help you with future planning and financial projections. Not only does this include the above expenses, but it also includes others such as interest on business loans and taxes.
Net profit = total revenue - total expenses
For example, your business earned $100,000 in total revenue in one year. However, the COGS totaled $15,000, operating expenses were $20,000, and you paid $5,000 in tax. Your net profit is calculated as $60,000.
Net profit margin
Now you know your net profit, you’ll typically want to calculate your net profit margin to understand your profitability ratio. A high ratio may indicate a healthier business at less risk of bankruptcy, and a low ratio may indicate potential risk due to pricing or inventory issues, for example. This is your revenue divided by your net profit, multiplied by 100.
Net profit margin = (net profit / revenue) x 100
For example, your business divides its net profit ($60,000) by its revenue ($100,000) to get 0.6. Multiplied by 100, its net profit margin is 0.60 or 60%. A 60% margin indicates the business earns 60 cents per dollar spent.
Profit and Revenue do not Mean Cash Flow
Earning income means your business may have profit and revenue, but that doesn’t mean you have steady cash flow to manage the day-to-day running of the business.
Cash flow is the movement of money; Expenses going out and income coming in are examples of cash flow. If you don’t have any income coming in, it’s hard to keep up with your expenses, such as materials to produce goods or paying staff wages.
Poor cash flow can mean the end for many businesses. After all, how can you sustain business operations when you have no cash to pay for anything? Only a business with zero expenses could manage that. A business line of credit is a business finance solution that can help keep things moving along by providing the cash flow needed to continue earning income.
Now you have a deeper understanding of just how different revenue, profit, and cash flow are, and the different types of metrics you can observe and calculate, you’ll be better prepared as a business owner to measure your success and efficiency in 2021.
If you’re looking for funding opportunities for your business activities, you can get in touch with Earlypay today on 1300 760 205 or sign-up using our sign-up form.