For many small business owners, especially those starting out, understanding the distinction between gross sales and net sales is crucial.
This is particularly relevant if your business is VAT-registered. In this article, we'll break down what gross sales and net sales mean, how they relate to VAT, and why this distinction is important for your financial reporting.
What are Gross Sales?
Gross sales refer to the total amount of revenue your business generates from selling goods or services, before any deductions.
If your business is VAT-registered, this amount includes the VAT you charge your customers. For non-VAT registered businesses, gross sales are simply the sales price of your products or services as there is no VAT involved.
For example, if you sell a product for £120, including VAT, your gross sales figure would be £120.
What are Net Sales?
Net sales, on the other hand, represent the actual revenue your business earns, excluding VAT and any returns, discounts, or allowances.
For VAT-registered businesses, this is the amount before VAT is added. The net sales figure is the one that directly impacts your business's profitability, as it reflects the actual sales income without the tax component.
Using the same example, if you sell a product for £120 (including 20% VAT), the net sales figure would be £100. The remaining £20 is VAT, which you are required to pass on to HMRC.
How to Calculate Net Sales from Gross Sales
Calculating net sales from gross sales is relatively straightforward for VAT-registered businesses. You can use the following formula:
Net Sales = Gross Sales / 1.2
For example, if you have gross sales of £120 and the VAT rate is 20%, the calculation would look like this:
Net Sales = £120 / 1.2 = £100
So, £100 is your net sales, and £20 is the VAT element that needs to be passed on to HMRC.
Why This is Only Relevant to VAT-Registered Businesses
If your business is VAT-registered, distinguishing between gross and net sales is essential because the VAT element needs to be reported and paid to HMRC.
You charge VAT on your sales and collect it on behalf of the government. This means the VAT portion doesn’t belong to your business—it’s a tax that you temporarily hold before remitting it.
However, if your business is not VAT-registered, you don’t need to worry about this distinction. Your gross sales figure is effectively the same as your net sales because there’s no VAT to separate. Non-VAT registered businesses simply charge their customers the sales price, which includes all the income for the business.
Profit and Loss Statements Only Show Net Figures
One area where business owners often get confused is in their profit and loss (P&L) statements.
Many expect the gross sales figures to show up in these reports, but this is not the case. P&L statements only reflect net sales because this represents the actual revenue your business has earned from its operations.
The VAT you collect from customers isn’t considered revenue because it doesn’t belong to the business. It’s a liability that you owe to HMRC.
Therefore, only the net sales figures—the amount you’ve earned from selling goods and services after VAT has been deducted—are relevant for calculating your profit.
Example:
Let’s say your business generates £12,000 in gross sales in a month, including 20% VAT. In your P&L statement, only £10,000 (the net sales) would appear as revenue, because that is the true amount earned from selling goods or services.
The £2,000 VAT would not be part of your P&L as it's not your business income, but rather a liability that needs to be paid to HMRC.
Conclusion
Understanding the distinction between gross and net sales, especially in the context of VAT, is essential for VAT-registered businesses. Gross sales include VAT, while net sales represent the actual revenue your business has earned, excluding VAT. This is crucial for accurate financial reporting and tax compliance.
For non-VAT registered businesses, this distinction is not necessary, as their gross sales figure is their actual revenue. It’s also important to remember that P&L statements only show net figures, which often causes confusion but ensures a true reflection of business profitability.
By keeping these principles in mind, business owners can ensure they are accurately recording sales and meeting their VAT obligations.