UNDERSTANDING THE TYPES OF PROFIT
We all know the expression “Cash is King” – but often people forget today’s cash is driven by yesterday’s decisions on pricing, “ingredients” and running costs, all of which determine profit. The Profit and loss report gives you the information to track and manage your sales and expenses and help you run a profitable business.
But when it comes to looking at your Profit & Loss (P&L) report what are all those different kinds of profit? – Gross profit, Operating profit, Net profit and then your accountant might talk about the Bottom Line – is this before or after tax? And then investors might ask you about EBIT and EBITDA… lets get demystifying!
First up a quick caveat – for some bizarre reason, some of the terms I am going to explain are defined slightly differently by different accountants and also whether you are UK or US based – so don’t be phased by this and there is no need to feel embarrassed to ask for clarification.
Here is a typical summary of your P&L report: “Standard Terms” and their Explanation
Sales: Sales invoiced in the month – NOT cash received and excluding VAT if you are VAT registered
Less Cost of Goods Sold: The “ingredients” costs ie bread/mayo etc in a sandwich business
= Gross Profit: Think of Gross Profit as your value added – this is what you are in business to create ie. in a sandwich business you took bread, boiled eggs, horseradish & anchovies and turned them into a high value sandwich – my favourite!
Less Overheads: The fixed costs of running the business ie rent, marketing, office costs
= Operating Profit: Operating profit which is before interest and tax, helps you compare profit between periods irrespective of the level of borrowing, interest rates or tax. Also known as EBIT (earnings before tax and interest)
= Profit before tax: Also known as PBT
= Profit after Tax: Aka “the bottom line”
Let me explain the types of profit
Gross Profit – this is sales less cost of goods sold and represents the “value add” that you are keeping. This is at the heart of your business model and your job is to push sales and cost of goods sold as far apart as possible but consistent with giving customers a “value proposition”. It is the Gross Profit generated that will cover overheads and make a profit. Often especially creative businesses do too much “polishing” of their product ie spend too much on ingredients (because they love it) – as a result they lose value and give it away to customers.
Operating Profit is Gross Profit less Overheads. It shows the profit of operations – before interest and tax. It is also known as EBIT – earnings before interest & tax.
EBITDA is your EBIT with depreciation and any amortisation added back. They are added back because they are both just accounting entries not reflecting cash – so EBITDA can then ne used as an approximation for cash flow by investors.
You will also come across the term margin in relation to profit as in Gross Profit margin and net profit margin. What this does is express the profit as a % of sales to help track movements in underlying profitability. So for example:
By using the % you can see that while the amount of gross profit in £ has gone up the profitability has gone down from 75% to 70% – maybe this was planned but maybe this is because of inefficiency in portion control or maybe a member of staff is pinching cash from the till ie sales were really £600 in month 2…
That covers the terms – so the big question is what should you be looking at? – all of them and on a regular basis!
The Gross Profit will show you how profitable you are at producing your good or service. The Gross Profit Margin (%) will help show the trend in efficiency. The Operating profit or EBIT shows how good your housekeeping has been – keeping your overheads as low as possible to retain as much of that Gross Profit as you can.
And the key thing is to get regular management accounts so you can pick up issues as soon as possible. If the only time you look at the accounts is at the end of the year – start doing it more regularly and see how the improved profit management flows into CASH!