The different types of profit measures and which is the most reliable

Julie Palmer

Regional Managing Partner

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What are the different types of profit measures and which is the most reliable?

Updated: 23rd February 2020

Measuring Profit: Which Method is Best?

In business it is widely accepted that profit is a good thing. If a company is in profit it is generally assumed that the company is performing well and the future is looking bright. However, is it as straightforward as this?

Unfortunately, as with many things in business, when it comes to profit, things are not so black and white. Profit comes in many forms rather than being a one size fits all term. Simply put, profit represents the difference between the income a company has achieved during a specific period of time and the expenses incurred over the same period to generate this money. However, the way profit can be measured is varied with some of these methods more reliable than others.

Due to this it can be difficult for an investor to determine how a company is actually performing. With varying profit calculations, the same figures are often interpreted differently depending on who is presenting the company’s performance. For example, how the company may want to position itself may differ to how the media may wish to paint its fortunes. Additionally, different analysts are interested in different aspects of a company’s performance and therefore will use the profit measure which best highlights this interest.

So what are the main profit calculations used by financial professionals, investors, and businesses, and what are the advantages and potential drawbacks when using these various measures to determine business performance? More importantly, what measurement is the most reliable indicator for determining a company’s current performance as well as its on-going health?

Gross profit – Gross profit considers a company’s revenue in relation to the costs involved in making the product. However, gross profit only looks at the variable costs required to produce the product such as the raw materials and labour, also sometimes known as Cost of Goods Sold (COGS). Crucially fixed costs are omitted; these include machinery, equipment, wages, and rent. As these costs are central to the company’s operations, removing these essential costs from the calculation, means many do not believe gross profit to be a particularly valuable way of analysing a company’s core profitability.

However, for those operating in certain sectors, particularly retail, analysing a company’s gross profit can be extremely enlightening. It allows for individual product lines to be compared in order to determine which are generating a positive income and those which are draining resources.

Gross profit margin is also a useful figure to monitor when a company is looking at increasing profitability as a whole. Increasing a company’s profit margin can be done by increasing prices, lowering production costs, or a combination of the two. Gross profit is the best way of determining how successful these endeavours have been without the figures being clouded by other costs not directly related to the production and sale of the company’s key products and services.

Operating profit – Includes variable costs, as well as the wider operating (or fixed) costs, involved in creating the product or delivering the service to the end user. Often referred to as EBIT (Earnings Before Interest and Taxes), operating profit takes into account the overheads involved in producing a product, however, it does not factor in other essential outlays the company is liable to make such as deductions for taxes.

"While profit is a good indicator of a company’s success and can hint at a bright future, the level of profit itself may not be the ultimate source of interest to a potential investor."

Net profit – Net profit considers both fixed and variable costs, as well as any deductions for tax and depreciation plus interest on company debt. This is typically the bottom line of the Profit and Loss (P&L) Statement and for many is the best measure of a company’s profitability. Essentially net profit looks at all incomings and all outgoings including those not central to the company’s production operations, such as any company held investments, royalties, or rental income. Due to this, net profit may be seen as giving the most accurate representation of how a company is performing and the money it is actually making, and to some extent this is right.

However, the problem with net profit is that as the figures encompass the entire operations of the company, poorly performing areas can easily be masked. For example, a company could hold an amount of stocks or other investments whose good performance could make up for the fact that the company is losing money on its principal services or products.

Retained profits – Retained profits are calculated as the net income minus the deduction of dividends paid out to shareholders. Of course this figure hinges much on the level of dividends taken; however, looking at a company’s retained earnings can still be useful. The amount of dividends distributed is often a reflection on the state of the company’s finances and performance; a successful period is often followed by large dividend payments. On the other hand, a less prosperous trading period not only means there is less money to be distributed, but low dividend payments also suggest a reluctance on the part of shareholders to extract vital cash resources from the company.

EBITDA – EBITDA stands for Earnings Before Interest, Tax, Depreciation and Amortisation. This approach considers purely the operating performance of the company as it does not take into account variables such as tax and interest payments. EBITDA gives investors a good indication of how efficiently the business is operating at the current time removed from the wider financial position of the company. This can be a particularly useful way for a potential purchaser to analyse a business’s performance and determine how this may fit into a wider portfolio.

While profit is a good indicator of a company’s success and can hint at a bright future, the level of profit itself may not be the ultimate source of interest to a potential investor. It goes without saying that a successful larger company will register greater profits than a smaller company; however, this does not mean that the large company with the bigger profit is necessarily performing better. What is important is the relative profit margin ratio; the bigger the ratio, the more efficient a company is performing. This can be an important factor when it comes to predicting the potential long-term growth of the company in question. So while the smaller company may be registering a lower profit than its larger competitors, if its profit ratio is greater, the potential for a more lucrative ROI is there.