There are many different measurements of profit that can cause confusion while presenting the financial statements. Our main goal here is to explain how to use the three types of profit and the differences between them in the most simple way possible.
Three types of profit measures that small business owners should be concerned?
Simply the gross profit is defined as revenue minus the cost of sales. Thus it is a key number when analyzing the Profit & Loss Statement. This metric will tell you the basic profitability of your center. It is key that the gross margin remain as high as possible in order to pay for below-the-line (operating) expenses such as indirect staff costs and administrative costs. The optimal gross margin percentage is higher than 30% which will provide the company with sufficient profit cover operating expenses, taxes, and provide a net profit.
Operating Profit or Earnings Before Interest, Taxes, Depreciation, Amortization
Operating Profit or EBITA (EE-bid-dah) is earnings before interest, taxes, depreciation, and amortization. EBITA is considered a good measure of the company’s operating efficiency since it completely ignores non-cash charges such as depreciation and amortization. Noncash items are added back in because they do not contribute to inflow or outflow of cash like other expenses. This simplification can be quite useful because it can mirror the actual cash flows of the business. However EBITA is often misused, since it results in considering too many cost items as unique thus boosting profitability.
The main number that the business should be concerned with is net profit which is normally the bottom line of the Profit & Loss Statement. Also known as what is left over after everything is subtracted. Remember, the net profit contains the non-cash elements that are excluded in EBITA. The net profit is the number that will normally be distributed or taxed in a small business.
Below are some quick profit definitions to help with the confusion with the three types of profit:
- Gross profit = sales revenue minus cost of sales and other direct costs
- Operating Profit or EBITA = Gross profit minus overheads and other indirect costs
- Net profit = sales revenue minus total costs
- Retained earnings = Profit after tax minus Dividends
Which of the three types of profit does you small business find most valuable?