Chapter 2: Profitability Metrics

Table of Content
➢ Gross Profit
➢ Net Profit and its Components
➢ EBIT (Earnings Before Interest and Taxes)
➢ EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization)

Gross Profit

Gross profit is the profit a business makes after subtracting all the costs that are related to
manufacturing and selling its products or services. You can calculate gross profit by deducting
the cost of goods sold (COGS) from your total sales. While calculating the total sales, include all
goods sold over a financial period, but exclude sales of fixed assets such as buildings or
equipment.

Formula: Gross Profit = Net Sales - COGS

What does gross profit tell you?

Gross profit is a measure of how efficiently an establishment uses labor and supplies for
manufacturing goods or offering services to clients. It is an important figure when checking the
profitability and financial performance of a business.

Gross profit helps you understand the costs needed to generate revenue. When the value of the
cost of goods sold (COGS) increases, the gross profit value decreases, so you have less money
to deal with your operating expenses. When the COGS value decreases, there will be an
increase in profit, meaning you will have more money to spend for your business operations.

Net Profit and its Components

Net Profit: Net profit, also known as the bottom line or net income, is the amount of revenue
remaining after all expenses, including operating expenses, interest, taxes, depreciation, and
amortization, have been deducted.

Formula:
Net Profit = Total Revenue - Total Expenses

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Net Profit = Gross Income - Total Expenses

Components of Net Profit:

• Net Sales: This is the total revenue a company earns from sales after subtracting returns,
allowances, and discounts. It forms the starting point for calculating profitability.

• Cost of Goods Sold (COGS): COGS represents the direct costs incurred in producing the
goods sold. Subtracting COGS from Net Sales gives Gross Profit. COGS directly impacts
Gross Profit. Higher COGS reduces Gross Profit, thus affecting Net Profit.

• Gross Profit: This is the profit a company makes after deducting COGS from Net Sales. It
indicates profitability from core business operations. Gross Profit is the starting point for
calculating operating profit. It reflects how efficiently a company manages its production costs
relative to its revenue.

• Operating Expenses: These are expenses incurred in the day-to-day operations of a

business, such as salaries, rent, utilities, and marketing. Operating Expenses are deducted
from Gross Profit to calculate Operating Profit (EBIT). Higher operating expenses reduce
Operating Profit and, consequently, Net Profit.

• Non-Operating Income and Expenses: These include items such as interest income,
interest expenses, gains or losses from investments, depreciation, amortization, and other
non-core business activities. Non-operating income adds to Net Profit, while non-operating
expenses subtract from it. They are considered after calculating Operating Profit.

• Taxes: Taxes are amounts paid to government authorities based on the company's taxable
income. They are deducted from Operating Profit (or Gross Profit, if Operating Profit is not
separately reported) to arrive at Net Profit.

How is Net Profit Calculated?

To calculate Net Profit, one must include all company’s financial transactions.

Net profit = Revenue/Sales + Income from other sources – Cost of Goods Sold – Operating
Expenses – Other Expenses – Interest – Depreciation – Taxes.

The cost of goods sold includes expenses on labour, raw materials, etc. Operating expenses
include fixed costs such as rent, advertising expenses, employee salaries, and insurance costs.
Interest costs are the interest payments the company makes on loans availed. Depreciation is
the reduction in the value of the asset over time. Taxes include corporate tax and so on.

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 Example of Calculation

Following is an excerpt from PQR Industries Limited’s Income Statement as of 30th March
2019. Take a look below to understand the components of the net profit formula better.

Particulars Amount (Rs)

Total Revenue 20,00,000
Cost of Goods Sold 5,00,000
Rent Rs 50,000
Utilities Rs 30,000
Depreciation Rs 20,000
Interest Rs 30,000
Taxes Rs 30,000

Net Profit = Gross Profit (Total Revenue - COGS) – Expenses

Net Profit = (20,00,000 - 5,00,000) - (50,000 + 30,000 + 20,000 + 30,000 + 30,000) = Rs

13,40,000.

EBIT (Earnings Before Interest and Taxes)

EBIT, also known as operating profit, measures a company's profitability from its core operations,
excluding interest and taxes. EBIT focuses on operating profitability, excluding non-operational
expenses like interest and taxes.

Formula: EBIT = Gross Profit - Operating Expenses

EBITDA (Earnings Before Interest, Taxes, Depreciation, and

Amortization)
EBITDA provides a clearer picture of a company's operational efficiency by excluding non-cash
expenses like depreciation and amortization, along with interest and taxes. EBITDA highlights
cash profitability by excluding non-cash and non-operating expenses, providing insight into
operational performance.

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Formula: EBITDA = Gross Profit - Operating Expenses + Depreciation + Amortization

Example:
Gross Profit: ₹200,000
Rent: ₹20,000
Salaries: ₹30,000
Advertisements: ₹30,000
Depreciation: ₹30,000
Amortization: ₹15,000

EBIT = 200,000 - (20,000 + 30,000 + 30,000) = ₹1,20,000

EBITDA = 200,000 - (20,000 + 30,000 + 30,000) + 30,000 + 15,000 = ₹165,000

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