Concepts
Net profit
Net profit is what remains of your income after all business expenses, including overheads and depreciation, have been subtracted, and it is the starting point for working out income tax.
Net profit is the bottom line of a business's income statement. It is calculated by taking total income and subtracting all the expenses of running the business, including cost of sales, wages, rent, insurance, advertising, interest and depreciation. If the result is positive, the business has made a profit for the period. If it is negative, it has made a loss. It is the overall measure of whether the business is earning more than it spends.
Net profit is different from cash flow. A business can show a net profit and still run short of cash, for instance if customers pay slowly, if the owner buys large amounts of stock or equipment, or if loan repayments are due. Conversely, a business can have cash in the bank and still be unprofitable. Looking at both profit and cash flow gives a more complete picture of how the business is travelling.
For tax, accounting net profit is a starting point rather than the final answer. Taxable income is worked out by applying tax rules to your income and deductions, and some amounts treated one way in your accounts are treated differently for tax. Examples include entertainment expenses, private use of assets, tax depreciation versus accounting depreciation, and non-deductible penalties. A tax agent usually reconciles the accounting profit to taxable income.
For sole traders and partners, net profit from the business is included in the individual's assessable income and taxed at their personal rates, along with other income. For companies, the company pays tax on its taxable income at the company rate. Trusts distribute net income to beneficiaries under the trust deed. The way net profit is taxed therefore depends on the structure, which is one reason structure choice is important.
If you are registered for GST, net profit should be calculated using GST-exclusive amounts. The GST you collect is not your income, and the GST you can claim as a credit is not your expense. If you are not registered, GST charged to you by suppliers is part of your cost and is included in your expenses. Mixing these treatments can distort profit and lead to errors in the return.
A common misunderstanding is believing that net profit equals the money you can take out. You may need to set aside amounts for tax, GST payable, superannuation, loan principal repayments and equipment replacement. Another is forgetting to include depreciation or the owner's own labour when judging performance. Regular reports from your accounting software help you track profit over time. This is general information only, so confirm your position with the ATO or a registered tax professional.
Worked example
A hair salon has income of $240,000 excluding GST. Cost of sales (products) is $30,000, wages are $110,000, rent is $42,000, and other expenses including depreciation are $28,000. Total expenses are $30,000 plus $110,000 plus $42,000 plus $28,000, which is $210,000. Net profit is $240,000 minus $210,000, which is $30,000, before any adjustments for tax purposes.
Practical tips
- Use GST-exclusive figures if you are registered, so GST does not distort your profit.
- Set aside money for tax, GST and super as you earn, rather than treating all profit as spendable.
- Remember that accounting profit and taxable income can differ, so let your tax agent reconcile them.