Understanding “Profit” In a Company

There are different elements of profits and they all signify different things in a business. It is the role of the investor to understand all the kinds of profits and to make decisions based on them effectively.

Making profit is one of the most important goals of any company; some might even argue that it is the most important goal of any business. In a general sense, profit refers to the extra money you make on your business above your investment in it.

However, the simplest way to explain it is to look at it in terms of the accounting statement: Profit is simply the excess of revenue over cost. That is, “Revenue – Cost = Profit.” For effective comparison of the profitability of companies, profit margins are used.

Profit margin is calculated by finding profit as a percentage of the revenue. It is stated as, “Profit divided by Revenue.” Profits themselves are used to determine which company is more economically viable because revenue might not be a good tool for comparison.

Take two companies for example: Company A makes a revenue of N100,000 with a cost of N10,000 while Company B makes a revenue of N500,000 with direct costs of N200,000. While it seems like company B is making more money than A, it is losing a lot of it to its direct costs.

The profit margin of company A is N90,000 (N100,000 – N10,000) divided by its revenue of N100,000 which is 90%. On the other hand, company B’s profit margin is N300,000 (N500,000 – N200,000) divided by its revenue of N500,000 which shows us a profit margin of 60%.

The profit figure might show you that the company has made a level of income, but because there are different elements of profit, a company might look like it is making a profit but be ultimately making a loss based on other factors.

It is why the profit margin of a company can be used to compare small businesses with big businesses. Some big businesses might seem better, but might be trapped in overhead costs or direct costs.

It also allows you see how businesses rank in a specific industry or even against competitors.

There are different types of profit in a company and different ways by which they are shown. They include: Gross profit, Operating profit, Net Profit in accounting, and EBIT and EBITDA in finance or investment. All of them tell you different things about the company.

The Gross profit which can be seen as the example above, deducts only the direct cost incurred in the process of making revenue. In accounting, this cost is referred to either as cost of goods sold or costs of sales.

It doesn’t account for fixed costs like huge equipment that the business might have bought before or even its rent.

Operating profit now deducts variable and fixed costs. It covers the direct costs already accounted for with the gross profit together with all administration costs like salaries, rent, and other operating expenses.

In accounting, depreciation and amortization are included in the determination of operating profit.

EBITDA shows you the profit before non-cash items like depreciation and amortization are considered. This is the line item many private equity investors show and this is because they are particularly interested in the general movement of cash.

EBIT is simply “Earnings before interest and tax”, deducting all expenses and costs except interest expense on loan repayments and taxes. Net profit then deducts every expense possible.

It deducts all expenses above together with taxes, interest expenses on loan, and so on.

Going back to our example, company ‘A’ having a profit margin of 90% might just end up spending a lot of money on its employees, interest expense for a huge loan it took for an equipment, depreciation of the equipment and end up with a net profit of 15% while company B might end up with a net profit of 30%.

It is important that the investor takes his time to understand the different elements of profit before committing his or her funds. You don’t want to have your investments simply used by the business to repay an old loan as opposed to actually building up.

Proper analysis and computations of this line item would certainly come in handy.

Written by Lawretta Egba.