Decoding profits

You are checking a company’s financial report and the words earnings and profit jump out from all over. Which profit should you consider while evaluating a company? What is the utility of so many profitability measures? How are the ratios—which analysts keep talking about—calculated? Money Today gives you a quick primer on understanding profits.

1. Gross profit

What it is: Sales minus manufacturing cost. Cost of goods sold is worked out by adding purchases made during the period to net stock.
What it means: Not total earnings of the company as it does not include ‘other income’ such as rent.

2. EBITDA

What it is: Earnings before interest, taxes, depreciation and amortisation. Calculated by subtracting operating, general, administrative and selling expenses from gross profit.
What it means: Not a true picture of profitability since it includes taxes and interest payments which can be very high for some companies.

3. EBIT

What it is: Earnings before interest and taxes. Also known as operating profit. Calculated by deducting depreciation and amortisation charges from EBITDA.
What it means: Shows how much the company earns from its core operations.

4. EBT

Item	Rs Crore
Net sales	10,000
LESS cost of goods sold	4,800
Gross profit	5,200
LESS operating expenses: General and administrative expenses	1,500
Selling expenses	850
EBITDA	2,850
LESS depreciation and amortisation	307.42
EBIT	2,542.58
LESS interest	402.06
EBT	2,140.52
LESS taxes	95.83
PAT	2,044.69
No. of shares (in crores)	30.56
EPS (Rs)	66.91
Market price (Rs)	780
Trailing P/E ratio	11.66

What it is: Earnings before taxes. Calculated by deducting interest expenses from EBIT.
What it means: Tax deductions for different companies are different. By including tax but not interest, EBT allows a fair comparison of how companies use borrowings to enhance the return per share.

5. NET PROFIT

What it is: Calculated by deducting tax from EBT. Also called profit after tax (PAT).
What it means: Since all payments have been made, it gives the final earnings of the company. Dividends are calculated on the basis of PAT

6. EPS

What it is: Earnings per share. Calculated by dividing PAT by number of outstanding shares.
What it means: It shows how much a company is earning on every share. Dividends on preference shares are not included while computing EPS.

7. P/E

What it is: Calculated by dividing current market price of shares by earnings per share.
What it means: Shows how much an investor is willing to pay for every one rupee of company’s earnings. Used by analysts to determine whether the company is under or overvalued.

Here is an illustration of how different profitability measures of a company are calculated. We have also listed three ratios for evaluating a company‘s performance

Operating ratio

It is calculated by dividing operating expenses by net sales (revenue). It shows what portion of revenue is taken away by operating expenses. Lower the ratio the better it is, as this indicates that the company has enough cash reserves for expansion and for interest payments.

Net profit ratio

It is PAT divided by net sales. This shows net income of a company on every sale worth Rs 100. A high ratio is better as it means the company has high profitability.

Debt equity ratio

It measures a company’s solvency and is calculated by dividing debt by equity. If the ratio is less than one, it means that the company is using more of equity and less of debt whereas greater than one means use of more debt than equity. High debt content can be risky for companies with volatile earnings since interest costs are fixed. Companies with high earnings can use high debt to enhance the returns for equity shareholders.