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Understanding profit at your small business can help you determine where to make changes to cut costs, price your product, take out loans, or sell shares in your business. — Getty Images/AsiaVision

Tesla, one of the best-known brands and arguably the most infamous electric car company in the world, took 18 years to become profitable. Amazon, too, consistently lost money for the first few years after it went public.

Profit is widely viewed as a reliable indicator of a company’s long-term performance and success. Understanding profit at your small business can help you determine where to make changes to cut costs, price your product, take out loans, or sell shares in your business. Here’s how to calculate profit and a few things to know about this important metric.

What is profit?

Profit is simply total revenue minus total expenses. It tells you how much your business earned after costs. Since the primary goal of any business is to earn money, profit is a clear indication of how your company is functioning and performing in the market.

There are three types of profit that can be found on your company’s income statement. These are:

  1. Gross profit
  2. Operating profit
  3. Net profit

Gross profit refers to the profit that results after deducting the costs of goods sold (COGS). The cost of goods sold is any expenses associated with creating and selling a product or providing a service. Calculate your company’s gross profit by subtracting COGS from revenue (e.g., sales). Gross profit is a way to isolate your variable costs to understand how efficiently your company is using things like labor and supplies to deliver a product or service.

Operating profit is calculated using the following formula: Gross Profit - Operating Expenses - Depreciation - Amortization. Operating profit provides insight into earnings over a certain period because it excludes profits from other investments and other asset-related metrics that don’t have bearing on what it takes to keep the business running. Compared to gross profit, operating profit is considered a highly accurate indicator of a company’s health.

Finally, net profit indicates the total profit after all the company’s expenses have been deducted from its revenues. This is an all-inclusive measurement often referred to as the “bottom line” due to its position on the income statement.

[Read more: How to Create an Accurate and Reliable Profit and Loss Statement]

Profit margin helps investors, the board of directors, lenders, and other key business leaders understand the company’s financial health, management's skill, and growth potential.

How to calculate profit margin

There’s another way to get a quick understanding of your company’s profitability, and that’s by calculating profit margin. Profit margin shows you what percentage of sales has turned into profit. For instance, if your company reports a 25% profit margin, that means it earned a net income of $0.25 for every dollar of sales generated. Of course, you can express profit margin as gross profit margin, operating profit margin, and net profit margin.

Profit margin helps investors, the board of directors, lenders, and other key business leaders understand the company’s financial health, management's skill, and growth potential. It’s more commonly used because it puts a company’s profit into perspective. It’s easier to compare a company’s profit margin to its peers and competitors than total net profit.

How to use profit and profit margin

Profit margin can help you compare your company’s performance with others in your industry. “For example, in the restaurant industry, margins are typically less than 10%,” Ken Wentworth of Wentworth Financial Partners told Business News Daily. “However, in the consulting world, margins can be 80% or more – oftentimes exceeding 100% to 300%.”

[Read more: How to Price Your Business Services]

Profit can also show you whether or not your company is spending its money wisely. Many companies aren’t profitable when they just start out. But lenders and investors will ask for profitability projections — a forecast of when they can begin to see a return on their investment as the company earns a profit. If you miss your targets, your gross and operating profit can help you see where you need to reduce spending or increase sales. Measure your profit on a quarterly, if not monthly, basis to track your progress.

CO— aims to bring you inspiration from leading respected experts. However, before making any business decision, you should consult a professional who can advise you based on your individual situation.

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Published May 17, 2022