So far we have covered sales or revenue—the top line—and costs and expenses. Revenue minus costs and expenses equals profit.
Of course, it might also equal earnings, net income, or even net margin. Amazingly enough, some companies use all these different terms for profit, sometimes in the same document. An income statement might have items labeled “gross margin,” “operating income,” “net profit,” and (if it is a public company) “earnings per share.” All these are the different types of profit typically seen on an income statement—and the company could just as easily have said “gross profit,” “operating profit,” “net profit,” and “profit per share.” When companies use different words right there in the same statement, it looks as if they are talking about different concepts. But they aren’t.
So let’s always use the term profit here and look at its various incarnations.
Gross profit—revenue minus COGS or COS—is a key number for most companies. It tells you the basic profitability of your product or service. If that part of your business is not profitable, your company is probably not going to survive long. After all, how can you expect to pay below-the-line expenses, including your own salary, if you aren’t generating a healthy gross profit?
Profit is the amount left over after expenses are subtracted from revenue. There are three basic types of profit: gross profit, operating profit, and net profit. Each one is determined by subtracting certain categories of expenses from revenue.
But what does healthy mean? How much gross profit is enough? That varies substantially by industry, and it’s even likely to vary from one company to another in the same industry. In the grocery business, gross profit is typically a small percentage of sales. In the jewelry business, it’s typically a much larger percentage. Other things being equal, a company with larger revenues can thrive with a lower gross profit percentage than a smaller one. (That’s one reason why Wal-Mart can charge such low prices—it’s so big.) To gauge your company’s gross profit, you can compare it with industry standards, particularly for companies of a similar size. (Many industry trade groups offer benchmarks for various financial and nonfinancial measures.) You can also look at year-to-year trends, examining whether your gross profit is headed up or headed down. If it’s headed down, you can ask why. Are production costs rising? Are you discounting too many sales? If gross profit is changing, understanding why helps you figure out where to focus your attention.
Here too, however, you need to keep a sharp eye out for possible bias in the numbers. Gross profit can be greatly affected by decisions about when to recognize revenue and by decisions about what to include in COGS. Suppose you run a market research firm, and you find that gross profit is headed downward. You look into the numbers, and at first it appears that service costs have gone up. So you begin thinking about cuts in service costs, perhaps even including some layoffs. But when you do more digging, you find that the accountants took some salaries that were previously in operating expenses and moved them into COGS. The change didn’t seem material to them, so they never told you. Now you realize that service costs did not go up, and that laying off people would be a mistake. So you have to talk with the accountants. Why did they move those salaries? Why didn’t they tell you? If those salaries are to remain in COGS, then maybe the firm’s gross profit targets need to be reduced. But nothing else needs to change. You can see that by asking a few more questions, and by understanding the potential estimates and assumptions in the numbers, you can develop better information on which to base your decisions.
Gross profit is sales minus cost of goods sold or cost of services. It is what is left over after a company has paid the direct costs incurred in making the product or delivering the service. Gross profit must be sufficient to cover a business’s operating expenses, taxes, financing costs, and net profit.
Operating profit—gross profit minus operating expenses or SG&A, including depreciation and amortization—is also known by the peculiar acronym EBIT (pronounced EE-bit). EBIT stands for earnings before interest and taxes. (Remember, earnings is just another name for profit). What has not yet been subtracted from revenue is interest and taxes. Why not? Because operating profit is the profit a business earns from the business it is in—from operations. Taxes don’t really have anything to do with how well you are running your company. And interest expenses depend on whether the company is financed with debt or equity (we’ll explain this difference in chapter 10). But the financial structure of the company doesn’t say anything about how well it is run from an operational perspective.
So operating profit, or EBIT, is a good gauge of how well you and your management team are running your business. It measures both overall demand for the company’s products or services (sales) and the company’s efficiency in delivering those products or services (costs). Bankers and outside investors look at operating profit to see whether the company will be able to pay its debts and earn money for its shareholders. If you share your financials with others, vendors look at operating profit to see whether the company will be able to pay its bills. (As we’ll see later, however, operating profit is not always the best gauge of this.) And if customers have an opportunity to see your financials, the larger ones examine operating profit to ascertain whether your company is doing an efficient job and is likely to be around for a while. Even savvy managers may check out the operating profit figures if they get a chance to see the financials. A healthy and growing operating profit suggests that managers and employees are going to be able to keep their jobs and may have opportunities for advancement.
Operating profit is gross profit minus operating expenses, which include depreciation and amortization. In other words, it shows the profit made from running the business.
However, remember that potential biases in the numbers can impact operating profit as well. Are there any one-time charges? What is the depreciation line? As we have seen, depreciation can be altered to affect profit one way or another. For a while, Wall Street analysts were watching public companies’ operating profit, or EBIT, closely. But some of the companies that were later revealed to have committed fraud turned out to be playing games with depreciation (remember Waste Management), so their EBIT numbers were suspect. Before long, Wall Street began focusing on another number—EBITDA (pronounced EE-bit-dah), or earnings before interest, taxes, depreciation, and amortization. Some people think EBITDA is a better measure of a company’s operating efficiency because it ignores noncash charges such as depreciation altogether.
Now, finally, let’s get to the bottom line: net profit. It is usually the last line on the income statement. Net profit is what is left over after everything is subtracted—cost of goods sold or cost of services, operating expenses, taxes, interest, one-time charges, and noncash expenses such as depreciation and amortization. When someone asks, “What’s the bottom line?” in reference to a company’s financial performance, he or she is almost always referring to net profit. Some of the key numbers used to measure a public company, such as earnings per share and the price-earnings (P/E) ratio, are based on net profit. Yet, it is strange that financial folks don’t call it profit per share and the price-profit ratio. But they don’t.
What if your company’s net profit is lower than it ought to be? Aside from monkeying with the books, there are only three possible fixes for low profitability. One, you can increase profitable sales. This solution almost always requires a good deal of time. You have to find new markets or new prospects, work through the sales cycle, and so on. Two, you can figure out how to lower production costs and run more efficiently—that is, reduce COGS. This, too, takes time: you need to study the production process, find the inefficiencies, and implement changes. Three, you can cut operating expenses, which almost always means reducing the headcount in your company. This is usually the only short-term solution available. That’s why we hear that so many CEOs who take over a troubled public company start by cutting the payroll in the overhead expense areas. It makes profits look better fast.
Of course, layoffs can backfire. Morale suffers. Good people whom the new CEO wants to keep may begin looking for jobs elsewhere. And that’s not the only danger. For example, “Chainsaw Al” Dunlap used the laypeople-off strategy a number of times to pump up the profit of companies he took over, and Wall Street usually rewarded him for it. But the strategy didn’t work when he got to Sunbeam. Yes, he slashed headcount, and yes, profit rose. In fact, Wall Street was so enthusiastic about the company’s pumped-up profitability that it bid Sunbeam’s shares way up. But Dunlap’s strategy all along had been to sell the company at a profit—and now, with its shares selling at a premium, the company was too expensive for pro spective buyers to consider. Without a buyer, Sunbeam was forced to limp along until its problems became apparent and Dunlap was forced out by the board.
Net profit is the bottom line of the income statement: what’s left after all costs and expenses are subtracted from revenue. It’s operating profit minus interest expenses, taxes, one-time charges, and any other costs not included in operating profit.
The moral? For most companies, and we bet yours is included, it’s better to manage for the long haul and to focus on increasing profitable sales and reducing costs. Sure, operating expenses may have to be trimmed. But if that’s your only focus, you’re probably just postponing the day of reckoning.
If you would like to try your hand at reading and analyzing an income statement to practice what you have learned—or if you just need a break from reading and want to do something—please turn to the income statement exercise in appendix B.