There are many terms you’ll come across when you begin running your own business, and if you have little financial or entrepreneurial experience then some of the phrases may seem a little foreign.
This article will break down two of the most used terms you’ll come across when running a business, and clarify the difference so that you feel more comfortable with the financial terms you’ll be using often. We’ll look at the following areas:
- What is revenue
- How to calculate revenue
- What is profit
- How to calculate profit
- The difference between revenue and profit and why it is important
What is revenue?
Revenue is the income a business brings in via sales on its main products and services before any expenses are subtracted.
It can be commonly referred to as ‘sales’ and this is the total cash value of all sales made by a business. You might hear it often referred to as the ‘top line’. It has this nickname due to the fact that revenue is found on the top line of an income statement.
Certain types of income do not count towards revenue. For example, any investments that generate income for a business, or smaller subsidiary companies that contribute to income are not counted in the revenue total, as it doesn’t come from the primary purpose of the business.
Revenue can also be called ‘net sales’ or ‘net revenue’ when seen on financial reports.
How to calculate revenue
To calculate the total revenue for your business over a certain period of time, add up the value of all your sales made in that time period. As mentioned, this total must be made up of your sales made, not from other types of income.
What is profit?
There are several types of profit, but generally speaking, when businesses talk about their profit it’s the total of sales (revenue), minus the business operating costs and the expenses incurred in making sales. These expenses are called the Cost of Goods Sold (or COGS) which can be the cost of raw materials used to make products, the total cost of ready-made products, the direct cost of labour needed to produce them, or any manufacturing and shipping costs. This type of profit is also known as Net Income.
Profit is often referred to as the ‘bottom line’ because it’s the final line on an income statement.
There are other names of profit that you may come across, such as gross or net profit:
- Gross profit is the total amount of money from sales (revenue), minus the total COGS.
- Net profit is the same as net income, so the total value of revenue, minus COGS and business operating expenses, such as rent, utilities, loans and salaries.
These ‘stages’ of profit are margins on the way to the final ‘net profit’ or bottom line that your business has made after all costs and expenses are deducted from the revenue.
How to calculate profit
Total up your revenue for a period of time.
Then total up the costs associated with producing the products you’ve sold, or your cost of providing services, for that same period of time (your COGS total).
Lastly, add up your business expenses and debts you have paid for the same period.
And finally, to work out the profit, you will use the following calculations:
Revenue – COGS = Gross profit
Revenue – COGS – Expenses = Net Profit
The difference between revenue and profit
When businesses refer to a company’s total profit, they are usually referring to the net income. We’ve seen that revenue is the total value of sales made, but that profit is what’s left after you deduct the expenses of running the business and making those sales.
Bear in mind, it’s possible for a company to generate a lot of revenue, but still, end up with a net loss at the same time. This happens when the operating costs and debts of the business are eating into the earnings made by sales.
Why is the difference between revenue and profit important?
It’s important to understand the difference between these two terms because you’ll find yourself preparing many financial reports during your time in business, and to get them wrong would mess up a lot of your accounting. It’s also important to understand each figure both individually and together, because it will give you an accurate picture of your company’s financial health.
While revenue will show you how well your business is doing in the current market, and if there is sufficient customer demand, your profit shows you if you are in a positive or negative financial position, because your debts and liabilities are accounted for in this final profit total. By understanding the difference you are able to highlight what business areas need improvement.
For example, if you have high revenue but little net profit, you need to look at your COGS and operating expenses to find ways to shave off costs. And if you have high revenue and high net profit, you’re probably striking a good balance and could afford to invest a little more in growing your business and scaling it up to the next stage.
You may have an accountant who supports you in your financial admin, but if you do not there are a few reports you should know how to prepare, which will include profit and revenue figures. These totals will be seen on:
- Income statement, which is also known as a profit and loss statement
- Cash flow statement
- Balance sheet
And finally, another reason you’ll need to have a clear understanding of profit and revenue as a small business owner is for tax purposes.
When filling in your self-assessment you’ll only be charged tax on the profit you’ve made. So, you need to know what your expenses are, your COGS and your total revenue figures, to be able to accurately calculate profit so that you only pay the tax you are due and not a penny more.
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