How to Read Financial Reports for Profit Types
A company doesn't actually make different kinds of profits, but it has different ways to track a profit on financial reports and compare its results with similar companies. The three key profit types are gross profit, operating profit, and net profit.
The gross profit reflects the revenue earned minus any direct costs of generating that revenue, such as costs related to the purchase or production of goods before any expenses, including operating, taxes, interest, depreciation, and amortization. The gross profit isn't actually part of the Chart of Accounts. You calculate the number for the income statement to show the profit a company makes before expenses.
The operating profit is the next profit figure you see on the income statement. This number measures a company's earning power from its ongoing operations. The operating profit is calculated by subtracting operating expenses from gross profit. Some companies include depreciation and amortization expenses in this calculation, calling this line item EBIT, or earnings before interest and taxes.
Others add an additional line called EBITDA, or earnings before interest, taxes, depreciation, and amortization. Accountants started using EBITDA in the 1980s because it gave analysts a number they could use to compare profitability among companies and eliminated the effects of financing and accounting.
Interest is a financial decision. A company has the choice to finance new product development or other major projects by selling bonds, taking loans, or issuing stock. If the company chooses to raise money using bonds or loans, it has to pay interest. Money raised by issuing stock doesn't have interest costs.
Believe it or not, taxes are also an accounting game. Most corporations report different tax numbers on their financial statements than they pay to the government because of various tax write-offs they're able to use to reduce their tax bill.
Companies don't actually pay out cash for depreciation and amortization expenses. Instead, depreciation and amortization are an accounting requirement that comes into play when determining the value of assets.
Net profit is the bottom line after all costs, expenses, interest, taxes, depreciation, and amortization have been deducted. Net profit reflects how much money a company makes. If the company isn't incorporated, it can pay out the profit to shareholders or company owners, or it can reinvest the money in growing itself. Firms add reinvested money to the retained earnings account on the balance sheet.