The formula
Net profit = total revenue - cost of goods sold - operating expenses - interest - taxes (including depreciation and other non-cash charges where applicable).
Work from the top of your income statement down.
- Revenue: total sales for the period.
- Minus cost of goods sold: direct costs of what you sold. This gives gross profit.
- Minus operating expenses: rent, payroll, insurance, marketing, software, vehicle, professional fees, depreciation.
- Equals operating profit.
- Minus interest and other non-operating costs; add other income.
- Minus income taxes where the entity pays them.
- Equals net profit.
For pass-through businesses, income tax is paid by the owner, so the business income statement may show profit before owner-level tax. Ask your accountant how your books present it.
Worked example
With $420,000 of revenue, $210,000 of direct costs, $150,000 of operating expenses and $10,000 of interest, pre-tax net profit is $50,000.
Illustrative example with round numbers.
| Step | Amount |
|---|---|
| Revenue | $420,000 |
| Cost of goods sold | -$210,000 |
| Gross profit | $210,000 |
| Operating expenses (incl. $12,000 depreciation) | -$150,000 |
| Operating profit | $60,000 |
| Interest expense | -$10,000 |
| Net profit before tax | $50,000 |
Net margin is $50,000 / $420,000, about 11.9 percent. Taxes depend on your structure and are not shown here. See how to calculate profit margin for the percentage version.
Get the inputs right: cash or accrual
Net profit depends on your accounting method. Accrual records revenue when earned and costs when incurred. Cash records them when money moves.
On the cash method, a December job paid in January counts as January revenue. On the accrual method, it counts in December. Accrual gives a truer picture of performance in each period; cash is simpler. Many small businesses use cash for taxes, but ask your accountant what is allowed for you.
Whichever you use, be consistent, and be careful comparing profit across periods or against other businesses that use a different method. Read cash basis vs. accrual accounting for the details.
Also check that you recorded all expenses, including ones that have not been paid yet.
Common errors that distort net profit
The usual culprits are missing expenses, mixing personal and business costs, treating loan principal as an expense, and forgetting depreciation.
- Personal spending in business books. It lowers profit incorrectly and creates tax risk. See separating business and personal finances.
- Loan principal treated as an expense. Principal repayment is not an expense; interest is.
- Owner draws counted as wages or the other way around.
- Equipment purchases expensed entirely when they should be capitalized and depreciated, or the reverse. Ask your accountant about the rules. See what depreciation is.
- Unrecorded accruals: unpaid bills, payroll taxes, unpaid commissions.
- Inventory not adjusted for what is actually on hand.
Net profit is not cash in the bank
Profit can be positive while cash is short. Loan principal, inventory purchases, owner draws and slow-paying customers all consume cash that profit does not show.
Illustrative example: your books show $50,000 of annual net profit. During the year you also paid $30,000 of loan principal, bought $25,000 of extra inventory and took $20,000 in owner draws, while customers owed you $15,000 more at year end than at the start. Cash fell by roughly $40,000 despite the profit.
Depreciation works the other way. It lowers profit but does not take cash out that month. Read cash flow vs. profit and what goes on a cash flow statement to connect the two.
Use net profit to make decisions
Compare net profit month to month and year to year. Investigate swings, test price changes and check that profit covers owner pay and debt.
Set a routine. Close the month, review the income statement, and ask three questions: Did revenue meet the forecast? Did any expense jump? Did margin hold?
Then ask whether the profit supports your plans. If you need $60,000 a year in owner pay but net profit is $50,000 after paying yourself nothing, the business does not yet support you at that level. Decide whether to raise prices, trim costs or grow volume.
Check taxes as well. Profit determines estimated tax payments, so keep a reserve. See tips for filing quarterly taxes.
Net profit when you apply for funding
Funders look at profit, but they also check bank deposits and cash flow. Be ready to explain any gap between the two.
Banks and SBA lenders review income statements and tax returns, so your net profit figure matters directly. Faster products lean on bank statements and revenue. In both cases, a clear explanation helps: a recent equipment purchase, a seasonal swing or a one-time expense.
Tax returns may show lower profit than you feel the business earns because of deductions like depreciation. Be prepared to explain add-backs.
ROI Funder considers 500+ FICO, 6+ months in business and $20,000+ monthly revenue, and asks for an application and three months of business bank statements for a complete file. See working capital and how to calculate loan ROI.
Frequently asked questions
What is the formula for net profit?
Revenue minus cost of goods sold, operating expenses, interest and taxes. It is the bottom line of the income statement.
Is net profit the same as cash flow?
No. Net profit is an accounting measure. Cash flow tracks actual money moving in and out, including loan principal, inventory and owner draws.
Is owner pay included in net profit?
Wages paid to owners through payroll are an expense. Draws by sole proprietors or partners are not, so profit may be before owner pay.
What is the difference between gross and net profit?
Gross profit is revenue minus direct costs. Net profit subtracts all other costs, including overhead, interest and taxes.