Why do my accounts show different types of profit?

Your accountant sends over your annual accounts and you open them in anticipation, your eyes scanning down the page for that all important figure. How much profit did I make last year? But wait a minute, there are two profit figures, maybe even three or four. Which profit figure should you be looking at? As ever in accounting, it depends what you want to know.

 

types of profit

Gross profit

Gross profit is what you have left from your sales income after you have deducted your direct costs (or cost of sales). Direct costs most commonly include materials, direct labour such as subcontractors and may also include inbound carriage on materials.

Direct costs are generally proportional to your sales. If you take on my joinery jobs, you will need to purchase more wood, nails, screws etc and might need to pay more subcontractors. If you cut and style more hair, you will need to purchase more hair dye, shampoo, hair spray etc

Your gross profit shows you how much income you have leftover after the direct costs in order to cover your business overheads such as staff or own wages, advertising, travel, rent, heat and light etc. The higher your business overheads compared to your direct costs, the higher gross profit you will need.

Gross profit margin is calculated by dividing gross profit by sales turnover and working out the percentage. This is a useful little indicator of how much of your sales income gets eaten up by your direct costs. You can have a really high sales turnover, bringing in lots of money but if nearly all of that money is being used to buy materials then you will have a low gross profit margin.  Someone like a consultant with no direct costs will have a high gross profit margin.

Sole Trader – Profit

If you operate as a sole trader then your accounts will just show gross profit and profit.

The profit is gross profit less your business overheads (staff or own wages, advertising, travel and subsistence, rent, heat and light etc). It gives a whole business view showing what is left after all the business expenses have been taken into account.

Profit margin is calculated by dividing operating profit by sales turnover and working out the percentage. It is useful to compare this to your gross profit margin to see how much income is being eaten up by direct costs and how much by administrative costs. You can also compare these figures year on year. If your business is growing but staying similar in structure then the margins would be expected to stay similar year on year even as the business grows. If they are changing, whether higher or lower, then it is a chance to ask why, to see look at what is happening.

The profit figure is what feeds into the self assessment tax return (with adjustments).

The final profit figure for a sole trader does not include any tax that is due. This is because the tax is due by the sole trader as an individual, not by the business. The tax amount might involve other sources of income such as employment or interest that are not related to the business.

Limited Company – Operating profit

Company accounts have to operate to more complicated standards to those of sole traders, even if the business itself is very simple. There are a number of extra profit headings in addition to the final figure.

Operating profit is gross profit less your business overheads (staff or own wages, advertising, travel and subsistence, rent, heat and light etc). It gives a whole business view showing what is left after all the business expenses have been taken into account.

Operating profit margin is calculated by dividing operating profit by sales turnover and working out the percentage. It is useful to compare this to your gross profit margin to see how much income is being eaten up by direct costs and how much by administrative costs. You can also compare these figures year on year. If your business is growing but staying similar in structure then the margins would be expected to stay similar year on year even as the business grows. If they are changing, whether higher or lower, then it is a chance to ask why, to see look at what is happening.

There are some types of income and expense that are not included in the operating profit; they have to be shown separately. For most small limited companies, the only ones they are likely to see are financial items such as interest paid or received on bank accounts.

Limited Company – Profit on ordinary activities before taxation

For many limited companies this figure will be the same as the operating profit, or the only difference will be the bank account interest.

The profit before tax figure is what feeds into the corporation tax return (with adjustments).

Limited Company – Profit after taxation

This shows the profit after corporation tax. For a limited company, unlike a sole trader, the tax due forms part of the accounts.

The corporation tax figure may be an estimate because the actual tax due will not have been finalised by HMRC when the accounts are prepared. It may also take into account some timing adjustments on capital allowances and depreciation (known as deferred tax).

The profit after tax figure is useful to limited companies because it shows how much profit is left to be declared as dividends. Dividends have to come out of the profits after tax.

Remember

The profit figure shown in your accounts may not be the amount that you actual pay tax on or the amount that you have actually taken out of the company. Accounting profit is not the same as taxable profit, which is not the same as earnings. You can find out more about this here.

So which profit figure do I need?

Which profit figure you use depends on whether you are preparing a tax return, working out your dividends, applying for a mortgage or examining elements of your business performance. All have a role and all can be useful to you in running your business.

Gross profit – income left after direct costs.

Profit – Sole traders. Income left after all business costs. Need for SA tax return.

Operating profit – Ltd Co. Does not include finance expenses or income.

Profit before tax – Ltd Co. Income left after all business costs. Need for corporation tax return.

Profit after tax – Ltd Co. Profit left after tax that could be distributed as dividends.

 

 

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