Understanding the Different Types of Profits
Understanding the Different Types of Profit Metrics
According to recent studies, nearly 50% of small businesses fail within the first five years due to various economic and financial reasons (Julija A., smallbizgenius). Among the list of contributing factors is mounting pressure from lenders, investors, and creditors to report a profit. Many business owners, regardless of size, struggle to understand the different components of profit, which leads to adverse effects on their business. Profit basics, main types, and the importance of different metrics are all key areas to understand when it comes to breaking small business failure statistics.
What is Profit?
Profit is the difference between your income and expenses during a specified time period. In order to be classified as profit, your income must exceed your expenses. If the opposite is true, you have a loss. Profit is also used in the investment industry to describe a financial gain from an investment. Income, frequently referred to as revenue, includes all payments from clients and customers for goods sold or services performed. On the other hand, expenses include costs to sell your product or service, such as office, advertising, supplies, and any other bill directly connected to your business. The bill must be reasonable, ordinary, and necessary to be a qualifying expense.
The Five Main Types of Profit Metrics
There are five main types of profit, all of which are found on your business’s income statement, sometimes referred to as a profit and loss statement. Each category of profit includes different financial data with some metrics resulting in a more favorable revenue number. As a result, many business owners choose to incorporate certain metrics when dealing with third parties to present their business with heightened financial health. One company known for misrepresenting financial health is Uber with executives creating a specified profit indicator to boost profitability even though overall business health is quickly deteriorating (Doctorow, Marker Medium). The five main types of profit performance metrics include:
Gross Profit
Gross profit only takes into consideration revenue and cost of goods sold. If you are in the manufacturing, construction or other industry that reports a high level of cost of goods sold, this profit metric will be applicable. However, for some small businesses, such as a consulting business or other online entity, there will be no direct costs applicable in cost of goods sold. As a result, the gross profit number will remain the same as your revenue.
Many businesses take advantage of the gross profit calculation to analyze trends in revenue and cost of goods sold between years. In addition, gross profit can be beneficial when determining product costs and how efficiently a company is using the cost of goods purchased. However, gross profit falls short because it does not include operating expenses, making it a metric that should be used in conjunction with other profit indicators (Beaver, Oracle NetSuite).
Operating Profit
Moving down the income statement, the next prevalent profit metric is operating profit. Operating profit takes into consideration revenue, cost of goods sold, and operating expenses to give your business a more accurate picture of where profitability falls for the year. Operating expenses include everything your business purchased or paid for in the ordinary course of business. Other expenses that are outliers of your regular expenses, such as government relief, are excluded from the operating profit calculation.
Operating profit is an advantageous calculation to get the full picture of all fixed and variable expenses your business incurred. When your business generates operative profit instead of operating loss, it indicates that you made enough income to cover all costs associated with running your business, excluding uncommon items. This is important to strategize for business growth to generate more profit. Nevertheless, operating profit does not include every income or expense item your business incurred, making it a great benchmark for continuing operations, but not a strong indicator for overall success.
Net Earnings Before Taxes
Net earnings before taxes should not differ drastically from operating profit since only a few items are added to the calculation. Common items found in the other income/expense category include interest income, interest expense, gain or loss on sale of fixed assets, miscellaneous income and expenses, and any other item that is not a regularly occurring business expense. With the recent pandemic, all COVID relief was reported in this category, resulting in higher income and expenses being reported.
Net earnings before taxes subtracts all outlier expenses from your operating profit or loss to see where your business ended up after weighing all other income and expenses. The result of net earnings before taxes highlights your business’s ability to remain profitable after paying down debt and funding operations. Investors and lenders will pay close attention to this number when figuring out your overall business health. On the downside, net earnings before taxes still excludes income tax expense which can be a large expense for many businesses set up as a corporation.
Net Earnings
Once you’ve reached the bottom of your income statement, you will find net earnings, commonly referred to as net income. Net earnings includes every single income and expense item, giving you information on whether you were profitable or lost money. Federal and state taxes are deducted from net earnings before taxes to produce the final bottom-line number known as net earnings.
Investors, lenders, and creditors will also frequently analyze this number to make financial decisions as it shows how well you are managing the income your business receives. Net earnings does take into consideration abnormal items that were incurred outside of the ordinary course of business so this number can fluctuate between years. However, understanding the factors that go into this calculation is critical to get a full understanding of your business’s financial health.
EBITDA
Earnings before income, taxes, depreciation, and amortization, also known as EBITDA, is not necessarily a profit metric, but it does consider the same factors. EBITDA adjusts the net earnings number by adding back interest, taxes, depreciation, and amortization. This should result in a higher profit figure compared to net earnings. However, if your business does not pay interest on loans, has no fixed or intangible assets, and pays taxes at the individual level, your net earnings and EBITDA will be the same number.
Putting Profit into Perspective
Understanding the five different profit metrics and where each one falls can be confusing. Looking at the sample income statement below puts the different profit metrics into perspective based on where they are found on the income statement.
As you can see, EBITDA is not included on the income statement. Generally Accepted Accounting Principles does not recognize EBTIDA as a valid profit indicator, condoning it to only be used for internal financial reporting purposes.
The Importance of Understanding the Different Metrics
Each profit metric serves a different purpose by including specified information. Gross profit and operating profit shed insight on how profitable your products and services are based on the cost. Net earnings before taxes and net earnings are useful to analyze the profitability of overall operations, including uncommon items. EBTIDA is prominent when it comes time to sell your business or when looking to secure additional funding through lenders and credits. Understanding the purpose of each metric is critical to utilizing the right indicator at the proper time.
Keeping Track of Different Profit Metrics
Your day-to-day schedule is bound to be busy as a business owner, which why taking advantage of the benefits an accounting system, like Subledger, is a great idea. Working with a user-friendly software promotes solid accounting features that leads to the creation of accurate profit metrics. When your business has the ability to generate reports through an accounting system, you can promote efficiency and productivity within your business by setting strategic goals. In most cases, the accounting system takes a majority of the burden off your plate, allowing you to focus on other key areas in your business.
Summary
Comprehending and utilizing the five different profit metrics is critical for long-term business success. Oftentimes, you know the ins and outs of your trade or service but may fall short on the financial reporting side, which is where Subledger can assist. Subledger is an innovative accounting system, designed to help your business focus on productivity through quick processing speeds without having to compromise data security. Reach out today to join the waitlist and get started taking advantage of the various benefits accounting with Subledger can lead to.
Sources
Beaver, Scott. “Gross Profit Margin: What It Is & How to Use It.” Oracle NetSuite, 23 October 2020, https://www.netsuite.com/portal/resource/articles/financial-management/gross-profit-margin.shtml#:~:text=Gross%20profit%20margin%20is%20good,companies%20with%20different%20sales%20revenues. Accessed 3 April 2022.
Doctorow, Cory. “End of the Line for Uber.” Marker Medium, 10 August 2021, https://marker.medium.com/end-of-the-line-for-uber-901e3077bbbc. Accessed 3 April 2022.
Julija A. “42 Small Business Statistics: Everything you Need to Know.” smallbizgenius, 11 March 2022, https://www.smallbizgenius.net/by-the-numbers/small-business-statistics/#gref. Accessed 3 April 2022.