Why understanding the difference between sales and net profit is vital for your business

On average 60% of UK business start-ups fail within the first 3 years. One of the biggest contributing factors to failure is running out of cash. You may have heard a business owner waxing lyrical about their business profits only for their business to fail. They were likely talking about their sales figures rather than the net profit. They are vastly different figures and not understanding the difference between sales and net profit can be disastrous.

Sales versus net profit

When you sell a product or service, the money you receive for this is your sales figure. Collectively, all the sales make up the business sales or turnover figure. There is a cost to producing the products your business sells, such as raw materials, equipment, premises costs, utilities, staff costs, etc.

The net profit of your business is the sales or turnover minus the costs of producing the product (cost of sales) minus the operating costs.

Cost of sales consists of costs directly attributable to the production of the product or service, such as raw materials used to produce an item.

Beware the cash illusion

Many business owners look at the healthy cash balance in the bank account, generated by lots of sales, and assume the business is thriving. This is the cash illusion and creates a false sense of security. Most companies have timing differences between receiving sales revenue and payment of production and business costs. This means the bank account balance at a point in time does not accurately reflect the performance and financial health of a business.

A basic example illustrating sales, cost of sales and net profit

We’ll use a side hustle selling personalised drawstring bags as a basic example illustrating sales, cost of sale and net profit. You already have a sewing machine and a laser cutting and design machine, so there is no requirement to spend money on production equipment. You’ll run the business from home so there won’t be any property overheads, other than a small increase in your electricity costs.

You’ve purchased a selection of fabrics, thread and transfers to make the drawstring bags. You’ve sensibly kept the receipts for your cost of sales purchases (raw materials) and have spent around £100. You are hoping to sell the bags for £15 each and estimate that you’ll be able to make around 20 bags a month, making you £300 in sales. You’ll sell them using a Shopify website that costs £20 a month to host. You estimate the postage and packaging costs will be £3 per bag – these are your overhead costs.

In this example, your sales figure is £300, your cost of sales or production cost is £100, and postage and packaging is £60 a month. Based on these figures, the sales or turnover figure is £300, cost of sales is £100, gross profit is £200 (sales less cost of sales) and net profit is £140 (gross profit less overheads). As you can see there is a significant difference between the sales figure of £300 and the actual net profit of £140. The table below provides a breakdown of the figures.

Financial accounts, cash flow and tax liabilities

The above example is simplistic, with record keeping for accounts and managing cash inflows and outflows relatively straightforward. Production materials are purchased first, sales income is received at the point of sale and overhead costs are paid when a sale is made. Staying on top of your accounts is important to calculate potential tax liabilities and ensure cash is available to pay the tax when due. Tax is one of the timing differences between accounts and cash flow, with tax paid around 9 months after the end of the business financial year.

Assuming a tax rate of 20%, in the above example, the monthly accounts will show a net profit after tax of £112, while the bank account will have a balance of £140 as the tax hasn’t been paid yet. This is called a timing difference and a wise business owner will transfer cash of £28 to a separate bank account setting aside the funds for when the tax bill is due.

Other timing differences when your business grows

Larger organisations have numerous timing differences impacting their bank account balance, such as variable timings of supplier and customer payments, VAT, PAYE, employer’s national insurance and business tax. This highlights how as a business owner you cannot gauge the success of your business by simply looking at your bank balance or sales figures. A successful business needs accurate accounts and cash flow forecasting to manage profitability and cash effectively.

A summary of the terms:

• Sales or turnover – the selling price of the product multiplied by the number of products sold.
• Cost of sales – the direct cost of production or raw material costs.
• Gross profit – Sales or turnover less cost of sales.
• Operating costs – costs of running the business, such as salaries, rent, stationery, travel etc.
• Net profit – Gross profit minus operating costs.