Knowing the difference between gross profit and net profit matters for 2 main reasons:
- You buy things to resell
- Your costs increase every time you make a sale
And that’s because it records the difference between your sales and what is costs you directly to make those sales. That difference represents your sales margin or markup. It is the first indicator of profitability in a business.
A while back I was watching an episode of Dragons Den (called Shark Tank in the USA) that reminded me of the confusion that abounds around the words: turnover, gross profit, net profit, profit margin, EBITDA and a bunch of other terms that have everything to do with how you view the profitability of a business.
Contestants on that show almost always fail when they get their numbers wrong (or worse – they don’t know what they mean). But luckily it’s easy. Read on…
Turnover or T/O (Total Sales)
This is your total sales figure. Literally, in money terms, how much you sold during a particular period (usually your financial year). Add up every bit of money that comes into the business with the exception of Sales Tax/VAT, loans, sale of capital items, and interest received and that is your turnover.
The reason loans, capital items and other money is not included is because they are usually not a core part of a business. So whatever it is a business sells as a normal part of its trading activities represents its turnover.
Turnover To Date means the turnover so far this financial year. From this you can start to make a prediction of your total turnover for the year. For example, if you’re 9 months into your year and your turnover to date is 75,000, then you can predict with some degree of certainty that your total turnover for the year will be 100,000.
If you have professional indemnity insurance you will need to have an idea of your forecast turnover for the current year. Most policies allow a degree of error of 50% (to make up for the uncertainty factor), but check your insurance small print.
Never confuse turnover with profit. Always quote turnover excluding VAT (or Sales Tax in the USA). If you quote turnover including tax, any potential investors will run a mile (they will see you as someone who likes to inflate figures). Sales Tax and VAT is not your money (you are just collecting it on behalf of the government) so it should never be included.
Gross Profit
If all you sell is a service. And there are no costs directly involved in supplying that service, then your gross profit is the same as your turnover.
However, if you resell goods or services, manufacture things for resale or have costs directly involved with selling what you do, then you need to remove those costs from your sales in order to arrive at your gross profit.
Typically these costs will be held in an account called Cost of Goods Sold (aka COGS). If you sell mainly services, this is often shortened to simply Cost of Sales (COS).
Here’s a simple example: You buy a widget at a cost of 100 and you resell it for 200. If you sell just one of these, your turnover will be 200. However, your gross profit will be 100 (because you must subtract the cost of the goods sold).
Other direct costs include shipping or postal costs (as these will not be incurred if nothing is sold). They will also include packaging of those goods, and if you manufacture them yourself, all the costs involved in that process (we know they are direct because unless you manufacture them, you won’t have anything to sell, plus everything you manufacture is for resale).
Compare this to the costs of renting your office and heating and lighting it. You have to pay all those costs whether or not you sell a thing. These costs are termed overhead costs. Salaries and wages are also part of your overhead so are not included in your gross profit calculation. These items are included later to determine your net profit (see below).
Gross Margin
Gross margin measures the gap between what it cost you to produce a product (or buy it for resale) and how much you got for it when you sold it.
Using the previous example, the gross margin is 50%. Gross Margin = (Selling Price less Cost Price) divided by Selling Price multiplied by 100.
As another example, if you sold a product for 200 which cost you 160 to buy or manufacture, your gross margin would be 20%. Here’s the filled in gross margin equation of that last example: (200 – 160) / 200 x 100 = 20
Like gross profit, knowing your gross margin is vital. And that means knowing with a good deal of accuracy your cost of goods or cost of sales. If you don’t know what it costs you to buy, manufacture and ship something, then you cannot set a price that you know will return a profit (and this is why so many contestants in Dragon’s Den and Shark Tank get eaten alive!).
Markup
Markup is another way of talking about margin. If you buy a product for 100 and you resell it for 200, you have marked it up 100%. If you bought something for 100 and wanted to mark it up by 25%, the selling price would be 125.
Most retailers operate on a markup of at least 100%. The exception is for commodities where the competition is usually so fierce, everyone is forced to compete on price.
Certain luxury goods also have the same problem, but in a different way. For example, Apple sell both online and in retail stores. They fix their own prices and ensure those prices remain high everywhere by selling on goods to other retailers with only a small discount. Note that price fixing in any other way (eg. trying to force your resellers to sell at a certain price) is illegal in most countries.
Net Profit
Be warned. There are multiple versions of Net Profit. The bottom line is your turnover less all costs. Your costs are not only Cogs and overheads but also depreciation of your assets, any amortisation of loans and just as importantly the tax liability on any profit made.
Accountants use different abbreviations to show exactly what degree of profit they are reporting. The most common is EBITDA.
EBITDA
EBITDA is an acronym for Earnings Before Interest, Taxation, Depreciation and Amortisation. In other words your turnover less COGS, overheads and other expenses. EBITDA is the most common way to report Net Profit.
You can quote on any subset of this. For example: EBIT = Earnings Before Interest and Taxation (so here we are including depreciation and amortisation).
Learn the above and you will impress any investor (and bank manager).
Frequently Asked Questions About Profit and EBIT
What is the definition of turnover in accounting?
Turnover refers to the total revenue generated by a company from its sales or services before any costs or expenses are deducted.
How is gross profit calculated?
Gross profit is calculated by subtracting the cost of goods sold (COGS) from total revenue.
What are the key differences between gross profit and net profit?
Gross profit only accounts for COGS, while net profit accounts for all expenses, including operating expenses, taxes, and interest.
How do you calculate net profit?
Net profit is calculated by subtracting all operating expenses, taxes, interest, and other expenses from gross profit.
What does EBIT stand for?
EBIT stands for Earnings Before Interest and Taxes and represents a company’s profit from operations before interest and tax expenses are deducted.
How do you calculate EBIT?
EBIT is calculated by subtracting operating expenses from gross profit but before interest and taxes are deducted.
What is the significance of EBIT?
EBIT provides insight into a company’s operational profitability by excluding the effects of financing and tax structures.
What does EBITDA represent?
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization and is used to show profitability before these non-cash expenses.
How do you calculate EBITDA?
EBITDA is calculated by adding back depreciation and amortization expenses to EBIT.
Why is EBITDA considered a useful measure?
EBITDA is seen as a proxy for cash flow and helps investors compare profitability across companies without non-operational effects.
What are the criticisms of EBITDA?
Critics argue that EBITDA can be misleading as it ignores the cost of capital investments (depreciation and amortization) and can overstate cash flow.
How does EBITDA differ from EBIT?
EBITDA adds back depreciation and amortization to EBIT, providing a more inclusive measure of operational profitability.
What is the impact of depreciation and amortization on net profit and EBITDA?
Depreciation and amortization reduce net profit but are added back in the calculation of EBITDA, thus not affecting it.
How can a company have a positive EBITDA and still have a negative net profit?
A company can have positive EBITDA and negative net profit if the depreciation, amortization, interest, taxes, or other expenses are high enough to exceed operational profits.
What is the role of turnover in assessing a company’s market position?
High turnover can indicate strong market demand and effective sales, reflecting a dominant market position.
How can gross profit margin be used to assess a company’s pricing strategy?
Gross profit margin can indicate how well a company is pricing its products and managing production costs.
What is the significance of net profit margin?
Net profit margin shows how much of each dollar of revenue is translated into actual profit, revealing overall efficiency.
How do changes in interest and tax expenses affect EBIT and net profit?
Increases in interest and tax expenses will reduce net profit but won’t affect EBIT since it’s calculated before these expenses.
Why might a company focus on improving EBITDA?
Improving EBITDA can make a company more attractive to investors by showing increased profitability and potential for growth.
How do investors use EBIT and EBITDA in valuation models?
Investors use EBIT and EBITDA in valuation models to assess a company’s profitability and compare it with peers, often as part of multiples like EV/EBITDA.
What is the percentage of gross profit margin?
The gross profit margin is a financial metric expressed as a percentage that compares the gross profit to total revenue. It’s calculated by subtracting the cost of goods sold (COGS) from total revenue and then dividing that number by total revenue.
Is it possible for EBITDA to exceed gross profit?
Yes, EBITDA can sometimes exceed gross profit if there are significant non-cash expenses or if the company has a low COGS.
For company directors, which is more advantageous: taking dividends or a salary?
The decision between taking dividends or a salary depends on individual circ*mstances, including tax implications, the company’s profitability, and the director’s personal financial situation.
Between EBIT, EBITDA, and Net Income, which is the best indicator for company valuation?
The best indicator can vary depending on the industry and the specific financial aspects one wants to analyze. EBITDA is often used for comparing companies within the same industry, EBIT provides a focus on operating profitability, and net income gives the bottom-line profitability including all expenses and income.
How do financial analysts and investors utilize EBIT in their evaluations?
EBIT is used to assess a company’s operating performance without the influence of tax and interest expenses, providing a clear view of profitability from core operations.
How can you transform gross profit into EBITDA?
To convert gross profit to EBITDA, you would add back any operating expenses, depreciation, and amortization to the gross profit figure.
What is the formula for calculating EBIT?
EBIT is calculated by subtracting the cost of goods sold and operating expenses from revenue.
What distinguishes EBIT from EBITDA?
EBIT includes depreciation and amortization expenses, while EBITDA excludes them, providing a measure of operating cash flow.
How much money should a company keep as a cash safety net?
A company should typically keep enough cash to cover 3-6 months of operating expenses, though this can vary based on the volatility of the business and industry.
Which is a better financial measure: EBIT or EBITDA?
Neither is inherently better; the choice depends on the context of the analysis. EBITDA can be useful for comparing companies with different depreciation policies, while EBIT is useful for looking at profitability after such non-cash expenses.
Does GMV represent the same as a company’s revenue?
No, GMV (Gross Merchandise Volume) refers to the total sales dollar value for merchandise sold through a particular marketplace, while revenue is the income a company receives from its normal business activities.
For your business, should you hire an in-house CFO or contract an outsourced CFO?
This decision depends on the size of the business, the complexity of financial operations, and cost considerations. Smaller businesses or startups might benefit from an outsourced CFO, while larger companies may require an in-house CFO.
When are my business tax filings due?
Tax filing deadlines vary by country and sometimes by business structure; it’s important to consult local tax laws or a tax professional for specific dates.
What is the meaning of EBITDA in accounting terms?
In accounting, EBITDA shows a company’s earnings with interest, taxes, depreciation, and amortization added back into net income.
What does the term ‘Annum’ refer to in finance?
‘Annum’ is a Latin term meaning ‘yearly’ or ‘per year,’ often used to describe financial figures that are calculated on an annual basis.
What is the initiative ‘Making Tax Digital’ about?
‘Making Tax Digital’ is a UK government initiative aimed at making it easier for businesses and individuals to get their taxes right and keep on top of their affairs through the use of digital records and online filing.
What constitutes operating income?
Operating income is the profit realized from a business’s operations after deducting operating expenses like wages, depreciation, and cost of goods sold from the gross profit.
What is a good gross profit margin?
A good gross profit margin varies by industry, but a higher percentage generally indicates a more profitable company that has better control over its costs.
What is business insurance and why is it important?
Business insurance protects companies against losses due to events that may occur during the normal course of business. It is important as it provides financial protection against common risks that can have significant financial impacts.
What is the ‘Rule of 40’ in business, and how does it aid in growth and profitability?
The ‘Rule of 40’ is a benchmark suggesting that a company’s combined growth rate and profit margin should exceed 40%. It is used as a guideline to balance growth and profitability in a way that can create sustainable long-term value.
