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What is Profit?

Kathleen ChaykowskiJanuary 10, 2020
Covered finance and business at Forbes and The Wall Street Journal. BA, Stanford University.
definition

Profit is a way to help measure how good (or bad) a company is at making money -- Its total revenue, minus total expenses.

🤔 Understanding profit

You can check-up on a company’s financial health by reading its earnings reports, which are produced regularly. One of the most important reports is the income statement, which calculates the profit — the bottom-line comparison of revenues to costs. In general, “revenue” (how much money a company generates) — “expenses” (the costs that come with selling goods or services, employee compensation, office leases, etc.) = profit. But take note, there are a handful of types of profit (gross profit, profit before tax, net income, etc.) that each reflect different levels of comprehensiveness in the calculation. Profit equation

example

Let’s find the profit of our beehive. We take the total revenue of the hive (the value of total honey sold) minus its costs (paying working bees and paying for housing for the hive), leaving behind the amount the hive gained or lost in that period. Here’s a rough sketch for how to calculate different types of profit on an income statement (for a real world example based on Walmart’s first quarter 2019 earnings, keep reading below):

Total Revenue -Cost of goods sold = Gross profit

-Sales expenses -Wages -Interest on debt = Profit before tax

-Taxes = Net income

Takeaway

Profit is like the honey produced from a company’s beehive…

It’s how much a company is earning or losing, based on the difference between the money it brings in (revenue) and what goes out (costs). There are different types of profit calculations, and some are more thorough than others. But they all help you measure how good a company is at making money.

Profit_Illo

Tell me more...

Walk me through a real world example
Why does profit matter to investors?
What’s the difference between profit, gross profit, profit before tax, net income, net profit, and net earnings?
What is the difference between profit, revenue, and sales?
What’s the difference between profit and profit margin?
What’s the difference between net profit and gross profit?
Can profit be negative?
Limitations on profit

Walk me through a real world example

Let’s use Walmart’s first quarterly earnings in 2019 as a case study to get the rundown on how to calculate gross profit, profit before tax, and net income.

We start with the “top line” of the income statement — revenue. This is the total, most comprehensive figure that represents what a company is raking in. Revenue is generated from the selling a company’s products and services, as well as any operations or assets that generate income.

Now, let’s calculate our first layer of profit, gross profit:

Gross profit: To calculate gross profit, we take Walmart’s revenue in the first quarter, $123.9 billion, and subtract its cost of sales in that quarter ($93 billion). ($123.9 billion - $93 billion) = gross profit of about $30.9 billion, for the quarter.

Profit before tax: To calculate Walmart’s profit before tax for the same quarter, we’d also deduct sales expenses and general and administrative expenses ($25.9 billion), and interest on debt ($625 million) plus gains on interest, $837 million. FYI, you’ll hear “sales, general, and administrative” expenses called “SG&A” for short, and it includes expenses like marketing or advertising, too.

The full equation: $123.9 billion (total revenue) -$93 billion (cost of sales) -$25.9 billion (administrative expenses) -$625 million (interest payments on debt) +$837 million (gains on interest) = about $5.2 billion (profit)

Net income: This is the most comprehensive, “bottom-line” calculation of a profit - the type of number crunching that’s done by your friend who color-coordinates their closet. It doesn’t get more holistic than this. Net income incorporates everything we’ve discussed so far but then also takes into account taxes.

Crunching Walmart’s first-quarter numbers: $5.2 billion (profit before tax) -$1.3 billion (taxes) = $3.9 billion (net income)

Why does profit matter to investors?

Profit is a no-nonsense way to judge how a company is really doing. It’s a powerful metric for measuring how good a company is at making money and assessing whether or not a company generates more money than it consumes. Important note, though: while it’s usually a positive sign if a company is profitable, it’s not necessarily bad if a company’s profitability is negative. In some cases, a company can still have significant sales, but may be using its sales to spend money on initiatives or costs that it believes will fuel future growth.

What’s the difference between profit, gross profit, profit before tax, net income, net profit, and net earnings?

Profit can be calculated in different ways, depending on how many sources of income and costs someone wants to consider. Gross profit, profit before tax, and net income (also called net profit or net earnings) are all examples of different variations of profit. Here’s a breakdown:

  1. Gross profit: Gross profit is the profit a company makes after the costs of producing and selling its products (known as the cost of goods sold, or “COGS”) are deducted from a company’s revenue, but before a bunch of other costs
  2. Profit before tax: This profit measure takes more costs into account than gross profit does, such as workers' salaries, interest on debt, and other financial obligations.
  3. Net income, net profit, net earnings: Three names for the same thing. Net income is the most comprehensive measure of profit out there. It incorporates all of the expenses considered in gross profit and profit before tax (the cost of goods sold, sales expenses, general and administrative costs, interest on debt, and financial obligations), as well as taxes. Net income also reflects any deductions a business might be able to claim.

What is the difference between profit, revenue, and sales?

While profit is the difference between the total amount of money a company makes (revenue) and expenses, revenue and sales are different measures of how much a company makes, without factoring in any expenses. Revenue is the most comprehensive calculation of how much a company brings in. Revenue includes sales (the total amount of money generated from selling the company’s services or products) as well as other sources of income. Examples of non-sales revenue include income from owned real estate, or any other income-generating source that isn’t a direct result of selling its product.

What’s the difference between profit and profit margin?

Profit is the difference between a company’s revenue and expenses, whereas profit margin is the percentage of profit a company keeps after removing costs. A high profit margin means it only costs a company a relatively small amount to produce and sell its products and services compared to the amount of revenue it takes in. A low profit margin means the cost of selling those products and services is closer to the price the company is actually able to place on those costs and services. In other words, it’s how much a company earns per dollar of total sales. It’s calculated as (revenue - cost of goods sold) divided by revenue.

Some industries, like restaurants, are known for being low-margin, meaning a higher percentage of the money made at restaurants goes to covering the costs of running the business. Software tends to have higher profit margins, because the costs associated with selling a software license are relatively low compared to the revenue generated.

The concept of margin can also be applied to other variations of profit, like gross profit and gross profit margin. Gross profit is calculated by subtracting the cost of products or services sold, from total revenue. Meanwhile, gross profit margin is a percentage that measures how efficiently a company generates revenue for each dollar of cost. The higher the gross profit margin, the more efficiently that company can sell its products and/or services.

What’s the difference between net profit and gross profit?

Net profit, which is also called net income or net earnings, is a more comprehensive profit calculation than gross profit - it’s the most comprehensive profit calculation out there. Net profit is the most complete profit figure because it takes more income sources and costs into account. Gross profit, meanwhile, is a less precise calculation — it subtracts the costs of selling products or services from the total revenue of those products.

“Gross” tends to mean “without taking into account all the costs.” “Net” tends to mean “after all costs have been accounted for”.

Can profit be negative?

You betcha. Some companies lose money, which happens if total revenue runs short of what it actually costs to run the business. In this case, profit is negative, which means that company is unprofitable. However, a negative profit doesn’t always signify something bad. Some companies run at a loss (a negative profit), but are investing the revenue they do have to fuel growth. The idea is that some growth companies sacrifice profits today in return for bigger profits tomorrow. Other times, negative profit can mean a company is genuinely struggling, and may not be sustainable in the long-term.

Limitations on profit

Profit is an important part of a company’s financial health, but not the whole picture. If you want to go to the beach, don’t just check to see if it’s sunny out. Check the temperature too — of the water and the air. Similarly, if you want to know how a company’s doing, don’t just check the profits. Profits (which are found on the income statement) say very little about the amount of debt (which is found on the balance sheet). Also, profit doesn’t necessarily mean the company is generating cash — for that, you must check the cash flow statement.

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