Net Profit – It isn’t what you think it is 

by Sean Foster | December 03, 2020 | Newsletter

At face value, one would naturally assume that the difference between Gross and Net profit is that Net is Net: the final, final! So, if I am reporting a healthy Net Profit then life must be all sweet.  

By definition, the Net Profit is the money left after paying for all the expenses in the business. The correct question to ask is this: 

“What are all the expenses that I should allow for in this calculation, and in particular, are any of these figures not used in the standard P&L report that you get from your accounting programme?” 

Why is this important? 

This is an easy one to answer: it is in your best interest to understand exactly how profitable your business really is. Businesses often under or over report their True Profitability and this not only affects their mindset and confidence about their business, but also their ability to raise capital and if not correctly understood, may come as a shock when they come to sell their business. 

The True Profitability is NOT reported in your accounting programme, but can be easily calculated and most likely is already being considered by your accountant. 

What is True Profitability? 

Basically, the TP, or True Profitability, takes your NP and makes additional adjustments so that you fully understand how your business is tracking in terms of its profitability. These are the two big adjustments to make: 

[1] Management salaries – every business needs to pay market related salaries. These salaries are unrelated to what you actually pay yourself. I would not recommend making reporting adjustments to everyone in the business, but for directors and working shareholders, then absolutely, yes. 

What would it cost the business for you to go to the market and to employ yourself? Compare this to what you are actually paying yourself (or the “drawings” you are taking in lieu of a salary. I have often found that the shareholder salaries can be +/- 50% of a normal salary.

This difference needs to be accounted for in the TP. 

[2] Depreciation – this one gets a little trickier, but is important. First up, when you look at your P&L, does it show depreciation? And secondly, is the depreciation amount reflective of the assets the business needs to operate? 

With our adjusted P&L, one that shows the “Truer Profitability” of the company, we need to understand the capital cost requirements to operate the company. Often the reported depreciation levels are far too high, or too low.

So, adjusting this level is really about making an educated judgemental call on what the adjusted depreciation level is. This cost represents the replacement cost of the necessary capital, spread out over a suitable time period. 

In the interest of keeping this NewsBrief short, I am keeping my explanations relatively short as well – but like always, I would welcome the opportunity to talk over these points if you so wish. 

Next Steps – now it is up to you. I am neither an accountant, nor a bookkeeper: in fact I am a little allergic to the subject. But what I do, is to help SME owners with better understanding and managing their financials from what I call a Managerial Accounting perspective, and you will need to have as a good, open-minded accountant on board.