The Income statement: Profits

So far we know that sales less all type of expenses results in profit. We know a little bit more – we know that sales less direct expenses results in Gross profit and Gross profit less indirect expenses ( including taxes ) results in net profit. In this lesson we will introduce two more variations of net profit – the PBIT , PBT and PAT. ( Profit before interest and tax , Profit before tax and profit after tax)

Gross profit

Companies need to generate a healthy gross profit to cover up indirect expenses, taxes, financing cost (all indirect costs) and net profit. But how much is ‘healthy’? That varies from industry to industry and from company to company. To analyse a company’s gross profit , you need to do two things :
1. Compare the Gross profit ratio with competitors in the industry  and
2. Compare the Gross profit ratio with the past 5 year’s ratio.
Comparison with the peers will give you an idea about how competitive the company is and by comparing the last 5 years’ ratio will tell you whether the company is headed up or down.

Operating profit or EBIT


Gross profit minus operating expenses results in operating profit. This operating profit is also know by another name – EBIT. I.e., earnings before interest and tax (Pronounced as EE-bit). Some companies may write the same as PBIT (Profit before Interest and taxes). What has not been deducted is interest and taxes. Why? Because operating profit is the profit a business earns from the business it is in- from operations. Interest expense depend on whether the company has taken a bank loan or not and taxes don’t’ really have anything to do with how well you are running the company. The EBIT will be displayed in the income statement of any company.

EBT-or Earnings before taxes.

…Or profit before taxes (PBT). The term implies operating profit after deducting interest expense.

PAT/EAT.

Now let’s get to the bottom line: Net profit. (Also called Profit after tax (PAT) / or Earnings after tax (EAT)]. PAT is what is left over after everything is subtracted- direct expenses, indirect expenses, interest and taxes. When the analyst says “the company’s bottom line has shown considerable growth” what he means to say is that the company’s PAT has gone up. Some of the key ratios used to fundamentally analyse a company such as Earning Per share and Price earnings ratio are based on this PAT.

To analyse a company’s PAT, you need to the same routine as you did in Gross profit analysis:

1 Compare the PBT  ratio with competitors in the industry  and
2 Compare the PBT ratio with the past 5 year’s ratio.
Comparison with the peers will give you an idea about how competitive the company is and by comparing the last 5 years’ ratio will tell you whether the company is headed up or down.

EBDITA-

Before we close this section we need to look at one more important version of profit called EBDITA or Earnings before depreciation, interest, taxes and amortization.( Amortization is something we haven’t explained. For the time being understand that it’s non cash expenditure.) Some people think that EBDITA is a better measure of a company’s operating efficiency because it ignores non cash charges such as depreciation.

How to calculate these ratios have been given in the “Fundamental analysis” section. For you as an investor , it’s enough that you take out the EBDITA, PAT and PBIT figures. A comparison of these figures with the peers a for the past 5 years would give you a first hand impression about the company.

You may like these posts:

  1. The Income statement: Understanding the components.
  2. The Income statement : Basics
  3. The Income statement : Understanding the “matching principle”.

1 Response to “The Income statement: Profits”

ajay varma

January 24, 2014 at 8:51 am

hi victor , your step by step approach is easy to understand , thank you

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