Profit is often regarded as the ultimate measure of financial success. It’s the driving force behind business growth, the benchmark against which investors gauge potential returns and an essential indicator of a company’s ability to create value.
But, while it’s the number that commands attention, profit tells only part of the story.
It’s not just about how much profit a company earns. It’s also about how efficiently it’s generated (relative to revenue) and what it suggests about the company’s future.
So, what is profit, why does it grab the headlines, and how do investors assess a company’s profitability?
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Profit and Its Importance
Profit is the total gain a company achieves after accounting for expenses. Calculated by deducting expenses from revenue (revenue – expenses), profit is one of many indicators of financial success.
The same equation that governs profit also governs financial losses. When expenses exceed revenue, the company yields a loss – it spent more than it generated in revenue.
While an indicator of success, profit also serves other important roles. Its importance and impact can be summarised in the following points.
- Valuation – companies with positive and growing annual profits tend to be more valuable.
- Financial metrics – profit is used to calculate several metrics investors use to assess companies.
- Internal source of growth and expansion – profit is often reinvested for future growth. It’s also used to help fund business expansion alongside external sources of capital, like debt.
- Impact on shareholder rewards – dividends are paid from a company’s profits. The more profit a company generates, the greater the available funds to reward shareholders.
Profit is more than just a gain and an indicator of financial success. It’s a multifaceted figure with wide-reaching implications.
Types of Profit
Profit is the general name given to the amount of revenue left over after accounting for business costs. But just as there are various categories of expenses, there are different types of profit.
The types of profit you will find on a company’s statement of profit or loss (income statement) include the following.
Gross Profit
Gross profit represents the revenue that remains after accounting for all direct costs. Direct costs, also called Cost of Goods Sold (COGS), are the costs associated with producing a good. Examples include the costs of materials used in production and wages for workers directly involved in production.
Gross profit is calculated in the following way.
Gross Profit = Revenue – Cost of Goods Sold (COGS)
Gross Profit Calculation Example
Let’s say Example Industries generated revenue of £1 billion from selling laptops in 2023. If the cost to produce these laptops were £400 million, Example Industries’ gross profit for the year would be £600 million.
Gross Profit = £1 billion – £400 million
Gross Profit = £600 million
Operating Profit
Operating profit represents the revenue remaining after deducting direct costs and operating expenses. Operating expenses include all the costs incurred to ensure the business continues to run. Some examples include rent, utilities and salaries.
Operating profit is calculated in the following way.
Operating Profit = Gross Profit – Operating Expenses
Operating Profit Calculation Example
Using the gross profit from above, if Example Industries’ annual operating costs amounted to £200 million, its operating profit would be £400 million.
Operating Profit = £600 million – £200 million
Operating Profit = £400 million
Profit Before Interest and Tax
Profit before interest and tax (PBIT for short) takes a company’s operating profit and adjusts it for non-operating income and non-operating expenses.
Non-operating income (income not generated by a company’s core business, like profits from selling an asset) is added to operating profit. Non-operating expenses (costs unrelated to a company’s core business, like investment losses) are deducted.
Therefore, profit before interest and tax (PBIT) is calculated in the following way.
PBIT = Operating Profit + Non-Operating Income – Non-Operating Expenses
Profit Before Interest and Tax Calculation Example
Carrying on from Example Industries’ operating profit, if the company sold some machinery for a £3 million profit and had investment losses of £5 million, its profit before interest and tax would be £398 million.
PBIT = £400 million + £3 million – £5 million
PBIT = £398 million
Profit Before Tax
Once a company’s interest expense is deducted, the “I” in PBIT is removed to give you PBT. In other words, profit before tax (PBT) is a company’s profit before interest and tax (PBIT) after accounting for its interest expense.
n.b. Interest expense only arises when a company takes on debt. If a company has no debt, profit before tax is calculated using the same formula as profit before interest and tax.
PBT is calculated in the following way for companies with an interest expense.
PBT = PBIT – Interest Expense
For companies with no interest expense, profit before tax is calculated in the following way.
PBT = Operating Profit + Non-Operating Income – Non-Operating Expenses
Profit Before Tax Calculation Example
Using the company’s PBIT from above and assuming Example Industries has an interest expense of £38 million, its profit before tax would be £360 million.
PBT = £398 million – £38 million
PBT = £360 million
If the company had no debt and therefore no interest expense, profit before tax would be £398 million.
PBT = £400 million + £3 million – £5 million
PBT = £398 million
Profit After Tax
Finally, the last type of profit (on a statement of profit or loss).
Profit after tax (PAT), or net profit, represents the revenue remaining after all business expenses are accounted for. It takes profit before tax and adjusts it for corporation tax.
Therefore, profit after tax is calculated in the following way.
PAT = PBT – Corporation Tax
Profit After Tax Calculation Example
Corporation tax is calculated by multiplying a company’s profit before tax by the corporate tax rate set by the government. Using Example Industries’ PBT (with the interest expense) and applying a 30% corporate tax rate, the company’s profit after tax would be £252 million.
Corporation Tax = £360 million x 30% = £108 million
PAT = £360 million – £108 million
PAT = £252 million
Profitability Ratios
For each type of profit, there are at least two financial metrics – a growth metric and a margin. Growth metrics highlight the annual change, while margins tell investors what percentage of revenue is left over after deducting expenses.
A general rule for profit margins is the higher, the better. The closer the margin is to 100%, the more efficiently a company generates profit.
Investors assess a company’s profitability using the following margins.
Gross Margin
Gross margin tells investors what percentage of revenue is left over after accounting for COGS (cost of goods sold). It is calculated using the following formula.
Gross Margin = (Gross Profit / Revenue) x 100
Using Example Industries’ figures from the above section, the company’s gross margin would be 60%.
Gross Margin = (£600 million / £1 billion) x 100
Gross Margin = 60%
Operating Margin
Operating margin tells investors what percentage of revenue is left over after accounting for COGS (cost of goods sold) and operating expenses. It is calculated using the following formula.
Operating Margin = (Operating Profit / Revenue) x 100
Using Example Industries’ figures from the above section, the company’s operating margin would be 40%.
Operating Margin = (£400 million / £1 billion) x 100
Operating Margin = 40%
Net Margin
Net margin tells investors what percentage of revenue is left over after accounting for all business expenses. It is calculated using the following formula.
Net Margin = (Profit After Tax / Revenue) x 100
Using Example Industries’ figures from the above section, the company’s net margin would be 25%.
Net Margin = (£252 million / £1 billion) x 100
Net Margin = 25%
Section Summary
Gross, operating and net margins are used and referred to the most because they assess a company’s core profitability – the profit generated from its primary business.
PBIT and PBT margins can also be used. But because they include non-operating items, they can vary wildly.
Summary
While profit is a company’s net financial gain, it serves other important roles. It’s a dynamic indicator that reveals how efficiently a company operates and creates value for its shareholders.
Understanding profit, why it matters, and how to assess it can empower investors to make better-informed decisions. The various profit margins, from gross to net, offer unique insights into a company’s underlying fundamentals, financial performance and health.
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