When you’re running your own business, you have a lot of responsibilities, and it can seem overwhelming, especially when you’re first starting out. It’s easy to get caught up in the day-to-day operations without taking a step back to analyze your financial situation. But as a small business owner, understanding your finances is fundamental to your success.
You don’t need an accounting background to effectively manage your finances, but you should at least be financially literate. To make sure you have the basics, we’ve outlined the need-to-know components of financial literacy for small business owners.
Each of these items is referred to in different ways, namely Gross Profit, Net Profit, and EBITDA. In this article, we explain to them to ensure that you understand what is being referred to when reviewing your business year.
What is Gross Profit?
Gross profit is the amount of profit made by the Company after deducting the costs of goods sold or the costs associated with the services the Company has provided. It is available on an income statement prior to deducting selling, general and administrative expenses (SG&A) and non-operating revenues, non-operating expenses, other gains, and other losses.
It is calculated as below:
Gross Profit Formula = Revenue – Cost of goods sold
Gross profit provides a simplified picture of the profitability of your products and services. It is a useful figure for an established business trialing a new product, where fixed expenses already accounted for within the larger company, therefore they are less an important indicator of the direct profitability of adding the new product itself. In terms of business process improvement, gross profit figures can also provide an insight into how effectively a management team controls the creation of products and services. For instance, looking at gross profit vs profit following the deduction of fixed costs you can drive cost-saving innovations and changes in both the manufacturing and sales processes.
What is EBITDA?
EBITDA, or ‘earnings before interest, taxes, depreciation, and amortization’, is a way of excluding non-operating activities from your figures, allowing you to focus in on the specific profitability of your business operations.
Similarly, EBITDA is helpful for investors, especially from larger firms, who may have different tax and depreciation arrangements to a business they wish to acquire. EBITDA provides investors with a simplified indicator of a business’ profitability, by removing factors potentially irrelevant to their own existing operating model.
What is Net Profit?
Net profit is often referred to as the ‘bottom line’. It concerns the total revenue of a business minus their total expenses and provides a more absolute figure than the somewhat more nuanced stats generated by EBITDA and gross profit figures.
When pitching your business to outside investors, net profit is an important figure. Several years of a positive net profit suggest that your gross profit is substantial and operating costs are efficient. This will increase your investment potential due to a reduced risk of a low return, or even loss, on investment.
EBITDA, gross and net profit all offer different perspectives on the success of your business, from particularly profitable products to the overall health of your business once larger, more fixed costs are accounted for. Understanding each, and their implications for your business’ short and long term objectives, is imperative in ensuring your long term security and prosperity.
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