In the world of corporate finance, companies use several different profitability metrics to communicate the state of their business to shareholders. A single company’s income statement has three different measures of profitability, each giving a different number.
Those three metrics are gross profit, operating profit, and net profit.
Each of these is derived from the first line item on the income statement: the total amount of income from the sale of goods or services. But each figure can tell you a different story about the company and its business.
How are these three key line items calculated and what do they tell you about the company?
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Gross Profit vs. Operating Profit vs. Net Profit
At the end of each accounting period (quarterly and annually), publicly traded companies are required to report on the state of their business. Companies report different types of profits, and investors can learn a lot by understanding these profitability measures and how they’re calculated.
Gross profit, or gross income, is the amount of money the company retains from its net sales after accounting for the direct cost of goods sold (COGS). These costs include items like direct labor, raw material, and the percentage of overhead costs directly related to the production of and storage of goods.
What Gross Profit Tells You
A company’s gross profit tells you the amount of money the company makes from selling its products and services after deducting the direct expenses from their production. This is an important figure because it tells you how efficiently the company converts raw materials, labor, and other costs of production into profits. It doesn’t include indirect costs like interest, taxes, and total overhead costs of running the business.
How to Calculate Gross Profit
The gross profit formula is as follows:
Total Net Sales – COGS = Gross Profit
For example, ABC & Co. generated $10 million in sales in the first quarter. The cost of goods sold during the quarter was $3.5 million. In this case, the formula would look like this:
$10 million – $3.5 million = $6.5 million (Gross Profit)
Real World Gross Profit Example
Let’s take a look at a real company’s financial statement to see how gross profit looks on these reports. See the screenshot of Apple’s income statement for the quarter that ended on December 25, 2021:
Apple’s total net sales came in at $123.945 billion. Its COGS, totaled in the line item “Total cost of sales,” was $69.702 billion. With these numbers, we know the formula looks like this:
$123.945 billion (Net Sales) – $69.702 billion (COGS) = $54.243 billion (Gross Profits)
Sure enough, the company reported gross profits (Apple uses the term “gross margin”) of $54.243 billion.
Operating profit, also called operating income, is the amount of money the company retains from net sales after deducting all production, overhead, and other operational costs. Operating expenses include COGS as well as other fixed and variable costs:
- Fixed Costs. Fixed expenses include costs like rent and insurance. These line items are easy to account for because they’re the same each accounting period.
- Variable Costs. Variable expenses include costs like utilities, payroll, freight and shipping, depreciation, and amortization.
In corporate finance, operating profits are also called earnings before interest and taxes (EBIT) because the line item accounts for all expenses the business will incur except for interest on debt and income taxes.
Note: Operating profit or EBIT should not be mistaken for EBITDA, which is earnings before interest, taxes, depreciation, and amortization. These similar-sounding acronyms measure different information.
What Operating Profit Tells You
Operating profits are the amount of money the company retains from net sales after deducting the costs associated with business operations. The metric tells you how efficient the business activities actually are by omitting line items like taxes and interest that the company has no control over.
Increasing operating profits, and operating profit margins, are a sign that the company is improving its operational efficiency, producing more return on operating cost investments.
How to Calculate Operating Profit
The operating profit formula is as follows:
Gross Profit – Operating Expenses = Operating Profit
Say ABC & Co. generated $6.5 million in gross profits in the most recent quarter. Its operating expenses clocked in at $2.8 million. In this case, the operating profit formula would look like this:
$6.5 million – $2.8 million = $3.7 million (Operating Profit)
Real World Operating Profit Example
Let’s refer again to Apple’s income statement for the quarter that ended on December 25, 2021, to see where operating profit appears:
Apple generated $54.243 billion in gross profits during the quarter. The company’s total operating expenses were $12.755 billion. In this case, Apple’s operating profit formula looks like this:
$54.243 billion (Gross Profit) – $12.755 billion (Operating Expenses) = $41.488 billion (Operating Profit)
As expected, Apple reported its total operating profit (operating income) for the quarter as $41.488 billion.
Net profits are also known as net income or simply the bottom line. These are the total revenues the company retains after deducting all expenses. Net profit accounts for tax, interest, and any other expenses that aren’t accounted for in gross profit or operating profit.
What Net Profit Tells You
Net profits show you how much money the company retains after accounting for all income and expenses. This is the ultimate metric for determining the company’s ability to convert income to profits.
How to Calculate Net Profit
The net profit formula is as follows:
Operating Profit – (Interest + Tax) = Net Profit
For example, ABC & Co. generated an operating profit of $3.7 million in the most recent quarter. Interest and taxes cost it $2.5 million during the quarter. In this example, the operating profit formula would look like this:
$3.7 million – $2.5 million = $1.2 million (Net Profit)
Real World Net Profit Example
Once again, let’s look at a real income statement for Apple’s quarter that ended on December 25, 2021:
Apple generated an operating profit (operating income) of $41.488 billion. Other expenses (representing interest costs) came in at $247 million and income taxes were $6.611 billion. In this case, the formula looks like this:
$41.488 billion – ($247 billion + $6.611 billion) = $34.630 billion (Net Profits)
Apple reported its net income for the quarter as $34.630 billion after deducting all its expenses.
Differences Between Gross Profit, Operating Profit & Net Profit
All three measures of profitability offer meaningful insight into the company’s financial wellbeing. The chart below summarizes the key differences:
|Gross Profit||Operating Profit||Net Profit|
|Accounts For||Cost of Goods Sold||Cost of Goods Sold and Operating Expenses||All expenses incurred during the accounting period.|
|Tells You||How efficiently the company produces its products and services.||The efficiency of the company’s overall operations.||The company’s ability to convert sales into profitability.|
|Advantage||Helps investors to understand if there are excess costs in the manufacturing and production process.||Helps investors determine if the company is allocating its capital properly within its operations.||Provides a meaningful gauge of the company’s overall success.|
What Are Profit Margins?
Profit margins are financial ratios used in corporate finance to provide a view of profitability in relation to a company’s total revenue. Like with profits themselves, there are three different types of profit margins:
Gross Profit Margin
The gross profit margin shows gross profit as a percentage of the company’s total revenue. The metric is calculated by dividing gross profits by total revenue.
For example, ABC & Co. generated $6.5 million in gross profits on $10 million in revenue in the most recent quarter. As a result, the company’s gross profit margin is 65%, meaning 65% of the company’s sales were turned into gross profits.
Generally speaking, a gross profit margin of between 50% and 70% is positive. In the example above, ABC & Co. scores on the high end of the spectrum.
Operating Profit Margin
The operating profit margin shows operating profit as a percentage of the company’s sales. It’s calculated by dividing the company’s operating profits by its revenue.
For example, ABC & Co. generated $3.7 million in operating profits on $10 million in revenues in the most recent quarter. Dividing $3.7 million by $10 million shows that the company has an operating profit margin of 37%, meaning 37% of its revenues were turned into operating profits.
In general, an operating profit margin above 15% is viewed as positive. If the above example were real, ABC & Co.’s data would suggest it’s doing exceptionally well.
Net Profit Margin
Net profit margin is the type of profit margin investors watch most. It is calculated by dividing the company’s net profits by its revenue.
For example, ABC & Co. generated $1.2 million in net profits on $10 million in revenue during the most recent quarter. Using these numbers, the company’s net profit margin was 12%, meaning 12% of its revenue turned into net profits after deducting all expenses.
Most investors view a 10% net profit margin as positive. In the example above, ABC & Co. is doing well.
Profitability is just one aspect of a company’s overall financial wellbeing. Investors should look into all financial statements when researching a company’s financial stability. These documents include:
- Income Statements. Income statements reveal a company’s profitability or lack thereof.
- Cash Flow Statement. The cash flow statement shows how cash is flowing into and out of the business.
- Balance Sheet. The balance sheet gives investors a snapshot of the company’s ability to meet its financial obligations.
You should always include an overview of the financial well-being of companies in your research before making a decision to invest.