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When calculating profitability, the different profit measures provide insight into the most significant factors that are creating corporate profit or loss. 

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Quick reference

Profit Measures

There are several calculated values found on the Earnings Statement that refer to different aspects of corporate profitability. 

When to Use Profit Measures

When calculating profitability, the different profit measures provide insight into the most significant factors that are creating corporate profit or loss.  Use these different measures whenever analyzing the Earnings Statement.

Instructions

  • There are four profitability measures that are often used for analysing business profitability.  Each of these can be found on the Earnings Statement.
  • The profitability measures can be positive or negative.  A positive value represents profit.  A negative number represents loss.
  • The most obvious is the final value of the Earnings Statement which is the Net Income.  This is the profit or loss earned by the company during the time period represented by the Earnings Statement.  This value is often used by the investing community.
  • The operating profit, also known as operating margin or Earnings Before Interest and Taxes (EBIT), is the value of profit before any interest charges or incomes taxes are subtracted.
    • This value is often used to measure the management capability of the general management team.  The general manager is able to control everything above this line and but the items below the line are often out of his or her control.  The interest charges were determined by the finance organization and capital markets and the taxes are set by the government taxing agency.
  • The gross profit, also known as gross margin or contribution margin, is a measure of the sales and manufacturing effectiveness of the organization.  It demonstrates the impact of selling one more item.  The costs of sustaining and running the business are excluded. 
    • It is often used as an indicator of short term profitability if there is a market shift.
  • EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation, and Amortization, is a variation of the operating profit measure.  In this case two of the items embedded in the operating expenses, depreciation and amortization, are also excluded from the calculation.  These values are automatic calculations that must be included on the Earning Statement because of previous investment decisions. 
    • This profitability measure is often used with a new management team in companies that have a high level of capital investments.  That is because the new management team has no ability to affect these values. Excluding them gives a better indication of the profitability of the current management team’s decisions.
  • Each of these profitability measures provides insight into how the business is being managed.

Hints and Tips

  • Make sure you know which measure is being referred to when discussing profitability.  Each measure provides insight on business performance.
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  • 00:02 Hi, this is Ray Sheen.
  • 00:04 Let's talk about some of the measures that a business uses to track profitability.
  • 00:11 All of these measures can be found on the earnings statement.
  • 00:14 The first one is called gross profit.
  • 00:16 Gross profit is the profit we have from selling more products, or
  • 00:19 doing more customer service.
  • 00:21 This is sometimes referred to as gross margin, or contribution margin.
  • 00:25 However, for purists, there's a slight difference between gross profit and
  • 00:28 gross margin.
  • 00:29 Gross profit is the actual amount on the earnings statement, and
  • 00:32 gross margin is the gross profit number expressed as a percentage of sales.
  • 00:36 In other words, gross profit is in units of money, and
  • 00:39 gross margin is in units of percentage.
  • 00:42 Contribution margin is the gross profit margin calculated for
  • 00:45 a single product rather than for the whole business.
  • 00:48 So, when people talk about contribution margin they are normally thinking
  • 00:51 at a product level.
  • 00:53 And gross margin is at a business level.
  • 00:56 Which ever measure you are using,
  • 00:57 you're measuring the businesses' operational performance.
  • 01:00 In particular, you are measuring the ability to efficiently perform the sales
  • 01:04 and operations functions.
  • 01:06 The only factors included in the calculation are the revenue from the sales
  • 01:09 and the cost of goods sold in the sale.
  • 01:12 This measure gives us a clear understanding of the financial
  • 01:15 impact of increased sales.
  • 01:17 The impact is not the entire revenue.
  • 01:19 We have to subtract out the cost of making the product or
  • 01:21 performing the service associated with what is sold.
  • 01:25 Another way to put it is that this indicates the lowest level that we
  • 01:27 would consider a price drop.
  • 01:29 We never want the price to be below the cost of goods sold,
  • 01:32 which would lead to a negative value for gross profit.
  • 01:35 So this measure tracks the relationship between sales revenue and
  • 01:39 the variable cost of making and delivering the product or service.
  • 01:42 On to the next measure, operating profit.
  • 01:45 As you can see, this is several lines further down the earnings statement.
  • 01:49 This is sometimes called operating margin, or EBIT, Earnings before Interest and
  • 01:53 Taxes.
  • 01:54 That is because the only thing left to subtract out of the operating profit
  • 01:57 to get to net income is just interest and taxes.
  • 02:01 Like gross profit, this is a measure of business performance, but
  • 02:04 I like this one better for a business measurement.
  • 02:06 The general manager has a great deal of control of what happens in everything
  • 02:10 above this line, the sales operations and operations or overhead expenses.
  • 02:16 And has very little ability to impact anything below this line.
  • 02:19 The general manager makes decisions considering operations and
  • 02:21 investments which are above this line.
  • 02:24 These are in the measurement.
  • 02:26 However in most cases, the general manager is not negotiating any loans or
  • 02:29 interest payments.
  • 02:30 That is the job of the company's CIO or treasurer.
  • 02:33 So interest and taxes will happen no matter what the general manager does.
  • 02:37 That's why I personally like operating profit as the best measurement for
  • 02:41 operating managers.
  • 02:43 The next measure is profit.
  • 02:45 Profit, net income, earnings, the bottom line of the earnings statement.
  • 02:50 These are the final answer to the question, did we make money?
  • 02:53 This measure is used much more externally than internally.
  • 02:56 Internally, we look at gross profit, or operating profit.
  • 03:00 This value is normally calculated and published for some time
  • 03:03 period tied to the company's fiscal calendar, usually a quarter or a year.
  • 03:07 The investment community tracks this closely.
  • 03:10 Since, in many cases, the level of dividends paid
  • 03:12 to investors will depend upon the reportable net income.
  • 03:16 The last profitability measure I want to mention is EBITDA.
  • 03:20 This stand for Earnings before Interest, Taxes, Depreciation, and Amortization.
  • 03:25 Like the others, it is a measure of business performance.
  • 03:28 But I find it used most frequently in long cycle businesses with high levels
  • 03:32 of capital assets.
  • 03:34 We will talk more about depreciation and amortization in other modules.
  • 03:38 What we need to know about this for
  • 03:39 this measure, is that these are charges to the business for decisions made in
  • 03:43 the past about the purchase of assets, both tangible and intangible.
  • 03:47 The current managers can do nothing to impact these.
  • 03:50 According to the accounting rules these charges must be recorded in this time
  • 03:54 period, even though they are not based upon decisions made in this time period.
  • 03:58 That is why some people believe this is a more accurate measure of the current
  • 04:02 management's ability to deal with the current issues.
  • 04:05 Of course, like EBIT, or operating profit it excludes the interest charges
  • 04:10 from the capital market and the effect of taxes by the government.
  • 04:14 Gross profit, operating profit, EBITDA, net income,
  • 04:18 use whichever profitability measure makes the most sense for
  • 04:22 your company or the one that is most commonly accepted.

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