What it means
The profit and loss account is built as a ladder. Revenue sits at the top, direct costs are taken off to give gross profit, operating expenses come off to give operating profit, then interest and tax are deducted to leave the net profit that belongs to shareholders.
Each rung answers a different question. Gross profit tells you whether the product itself makes money, operating profit tells you whether the business as a whole works before financing choices, and net profit tells you what the owners actually earned.
Profit is not cash, and confusing the two ruins more businesses than low margins do. Revenue is recorded when it is earned rather than when it is collected, so a profitable company can still run out of money if customers pay slowly, stock builds up or capital spending outruns the cash coming in.
What the company then does with the profit is a separate decision. Some is paid out as dividends and the rest is added to retained earnings on the balance sheet, funding growth, repaying debt or building a buffer against a downturn.
Comparing profit across companies only works once it is expressed as a margin. A $5,000,000 profit is impressive for a business turning over $20,000,000 and disappointing for one turning over $400,000,000, which is why analysts talk in percentages rather than absolute figures.
In practice
Real-world examples.
Example
A software company reports a 78% gross margin but only a 4% net margin, because almost all of its revenue is consumed by sales commissions and research spending. Investors accept the low net figure while growth is fast, on the expectation that operating costs will rise more slowly than revenue.
Example
A grocery chain earns a net margin of about 2%, which sounds thin until you notice it turns its stock over roughly twenty times a year. The small margin applied repeatedly to a very large sales figure produces a substantial absolute profit.
Example
A manufacturer posts record net profit of $12,000,000 in a year when $9,000,000 of it came from selling a surplus site. Analysts strip out the one-off gain and note that underlying trading profit actually fell compared with the previous year.
Formula
Calculation
The ladder in formula form:
Gross profit = revenue - cost of goods sold
Operating profit = gross profit - operating expenses
Net profit = operating profit - interest - tax
A specialist bakery supplier reports revenue of $8,400,000 for the year with cost of goods sold of $4,620,000, so gross profit is $8,400,000 - $4,620,000 = $3,780,000, a gross margin of $3,780,000 / $8,400,000 = 45%.
Operating expenses, covering salaries, rent, delivery and marketing, total $2,520,000. Operating profit is therefore $3,780,000 - $2,520,000 = $1,260,000, an operating margin of $1,260,000 / $8,400,000 = 15%.
Interest on the company's equipment loans is $160,000, giving pre-tax profit of $1,260,000 - $160,000 = $1,100,000. At a corporate tax rate of 21% the charge is $1,100,000 x 0.21 = $231,000, leaving net profit of $1,100,000 - $231,000 = $869,000 and a net margin of $869,000 / $8,400,000 = 10.3%.Case study
Seen in the real world.
The following is an illustrative and fictional example. Bramblewick Furniture, an invented maker of office fit-outs, grew revenue from $6,000,000 to $9,000,000 in two years and reported net profit rising from $480,000 to $702,000, a net margin holding steady at 8% then slipping to 7.8%.
The board was pleased until the finance director laid the cash flow statement alongside the profit figures. Receivables had grown from $1,000,000 to $2,300,000 as the company won larger corporate clients who paid on 90-day terms, and stock had grown by a further $600,000 to support the wider product range. Cash generated from operations was negative $180,000 in the second year despite the reported profit.
The fictional company responded by tightening its terms rather than chasing further growth: deposits of 30% on all orders above $50,000, a credit check before quoting, and a discount for payment within fourteen days. Revenue growth slowed to 6% the following year, but operating cash flow swung to a positive $640,000, and the illustrative moral is that profit is an opinion about timing while cash is a fact.
Watch out
Common mistakes.
- Treating profit and cash in the bank as the same thing, when timing differences in payments, stock and capital spending separate them completely.
- Comparing profit figures between companies without converting them to margins, which makes businesses of different sizes look artificially different.
- Judging performance on headline net profit without stripping out one-off items such as asset sales, legal settlements or restructuring costs.
Questions
People also ask.
Which profit figure should a manager focus on?
Operating profit for judging how well the business itself is run, since it excludes financing decisions and tax positions that management may not control.
Why do two companies in the same industry report such different tax charges?
Differences in loss carry-forwards, capital allowances, the countries they operate in and the treatment of research spending can all move the effective rate substantially.
Is a rising profit always good news?
Not necessarily, because it can come from cutting maintenance, marketing or research that the business will need later, so the quality of the profit matters as much as the amount.
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