It's that time of the year when quarterly reports flood mailboxes and dailies, and the words 'earnings' and 'profit' jump out from all over. But which profit should you consider to evaluate a company? What is the utility of profitability measures? Here's a guide to understanding profits.
1) Gross Profit
What is it? It is the amount earned from sale of products after deducting production costs.
What it does: Signals efficiency with which a company is making money. Indicates how much mark-up a company can generate on its sales.
Other clues: A company with rising gross profit means it can command premium prices. This also implies cost efficiency, making the company highly competitive.
Black spots: Works as a primary indicator. Gross profit is similar to an incomplete story. To know more about a company, you have to read other signs.
2) Ebitda
What is it? It means earnings (or profit) before interest, taxes, depreciation and amortisation. It is calculated by subtracting operating, general, administrative and marketing expenses from gross profits.
What it does : Measures profitability. Say, you are having trouble deciding between companies, it is the best tool to compare them because it weeds out the effects of financing and accounting decisions.
Other clues: You can also compare sectors.
Black spots: Ebitda is not a good measure of cash flows. Companies may use it to dress up earnings.
3) Ebit, or operating profit
What is it? Ebit is earnings before interest and taxes. It is calculated by deducting depreciation and amortisation charges from Ebitda.
What it does: Measures a company's earning capacity. An effective comparison tool. Examines performance of companies by negating the effects of financing and taxes. It is useful for shareholders and creditors.
Black spots: Suffers from similar problems as Ebitda—it ignores unavoidable cash outflows due to interest and taxes.
4) EBT
What is it? EBT is earnings (or profit) before taxes and is calculated by deducting interest expenses from Ebit.
What it does: Compares companies in different tax jurisdictions. It is useful for comparing companies within a sector. EBT also shows how well a company is using its borrowings to enhance its return on equity.
Black spots: Again, doesn't give a wholesome picture. Discounting the tax effect is unwise. Say, investors have to choose between two Indian companies. Company A operates in India and Company B has most of its operations in the US. A is posting record profits and B's earnings per share are marginally lower.
Investors would be tempted to pick Company A, but what if corporate tax in India is about to be raised? Then, Company A's profit could fall below Company B's.
5) EAT, or net profit
What is it? Earnings after tax, or net profit, is the most common way to calculate a company's profit. EAT is the company's profit after deducting manufacturing and operating expenses, depreciation, interest and tax.
What it does: Tells the story of a company's performance over a period. Handy tool for equity shareholders as it is the money left after a company makes all payments.
Other clues: EAT helps shareholders analyse the earnings of a company on a per-share basis. Equity dividends are also based on EAT.
