Part 1, Lesson 4
In Part 1, Lesson 3, we completed the final January income statement for John’s Pizzeria, which is shown below:
John’s Pizzeria – Income Statement
For the Period Ending January 31, 2019
Revenue $16,000 – Cost of Goods Sold ($8,000) = Gross Profit $8,000 – Salary Expense ($4,000) – Rent Expense ($1,000) – Electric Utility Expense ($500) – Supplies Expense ($250) – Depreciation Expense ($500) = Operating Profit $1,750 – Interest Expense ($1,000) = Earnings Before Taxes $750 – Income Tax Expense at 40% ($300) = Net Income $450
There were three important terms that popped up in this income statement: 1) Gross Profit, 2) Operating Profit, and 3) Net Income. These terms are referenced constantly in the financial press and research reports, so it is imperative to understand the differences between these three terms. We will also introduce a new metric, EBITDA.
Gross profit is simply Revenue minus Cost of Goods Sold (COGS). Gross profit typically refers to the dollar value, while gross margin refers to the percentage (gross profit / revenue). However, in practice, many people use these words interchangeably.
Gross margin (percentage) is a useful metric when comparing businesses in the same industry. For example, John’s Pizzeria is showing a gross margin percentage of 50%. Let’s assume we obtained an income statement for Sally’s Pizzeria down the street, which showed a gross margin percentage of 80%. This would raise some serious questions for John’s business. Why is Sally achieving so much of a higher gross margin vs. John? Is she using a cheaper supplier? Is she making her pizzas in-house? Knowing the answers to these questions could have significant implications for how John runs his business.
If John were to improve his gross margins to 80%, this would imply gross profit dollars of $12,800. This is a material difference in profitability.
The comparison of accounting metrics (such as gross margins) across multiple companies is a process known as “benchmarking.” John, as the owner of John’s Pizzeria, would benefit significantly from benchmarking his business vs. comparable pizzerias as it may give him ideas on how to run his business better.
Two more important points:
- When benchmarking gross margins across businesses, you must be sure that the Cost of Goods Sold (COGS) does not include depreciation expense. Many businesses will allocate a portion of their depreciation expense into COGS, while others will not. To make proper comparisons, you must ensure that gross margins exclude depreciation.
- Many public company income statement will not show a line item called “Gross Profit.” As you become more familiar with income statement presentations, it will be up to you to calculate gross profit and gross margin percentages on your own.
Operating profit is equal to gross profit less all remaining expenses except for interest expense and taxes. Operating profit refers to the dollar value, while operating margin refers to the percentage (operating profit / revenue). Similar to gross profit, many people use the terms operating profit, operating margin, and operating income interchangeably.
For John’s Pizzeria, the January operating profit was $1,750 and the operating margin was 10.9%. Similar to gross margin, operating margins can be useful when comparing businesses in the same industry. For example, if Sally’s Pizzeria is running at the same gross margin at John’s but is showing an operating margin of 20% vs. John’s Pizzeria at 10.9%, then, this should prompt John to study which expense items are contributing to lower operating margins in his business vs. Sally’s. It could be that Sally is paying lower salaries or has more favorable lease terms.
Operating profit is also commonly referred to as EBIT or Earnings Before Interest and Taxes. When constructing an income statement, interest expense and taxes are typically the final two expenses to deduct from EBIT to arrive at net income.
Net income is the final line item of the income statement. It shows the net amount earned after deducting all expenses incurred from revenue recognized. This is the amount of profit that is available to the owner of the business. Dividends to the owner of the business can be paid out of positive net income that a company generates.
Importantly, net income is not necessarily equal to the amount of cash coming in the door for that period since most income statements are constructed based on the accrual method, not the cash method. For example, depreciation is a non-cash expense, which means that cash is not going out the door for depreciation.
When investors refer to “Earnings Per Share” or “EPS,” they are referring to the Net Income of a company divided by its total shares outstanding. EPS is commonly used to value company stock prices through the use of Price / EPS multiples.
The accounting metric, EBITDA, is one of the most commonly used terms in the investment world. EBITDA stands for Earnings before Interest, Taxes, Depreciation and Amortization. After subtracting out Depreciation and Amortization, EBITDA becomes EBIT (or as mentioned above, operating income).
EBITDA is a commonly used metric because it provides for a good approximation of pre-tax and pre-interest cash flow. Because some companies may have different leverage levels (amount of debt) or some companies may reside in low tax jurisdictions vs. high tax jurisdictions, EBITDA provides for a relatively clean baseline in which to compare profitability while controlling for some of these idiosyncratic differences.
Question – In the January income statement for John’s Pizzeria, what is the EBITDA for the month of January?
Answer – To calculate EBITDA, we take the operating profit (EBIT) of $1,750 and add back the $500 depreciation expense. This results in $2,250 of EBITDA for January.