What is a firm’s true profit?

If you're considering investing in a company, one of the first things you'll want to know is how much money, or profit, it makes. That may sound simple – after all, profit is just the difference between a company's sales (also known as turnover or revenues) and its costs. However, look at a set of accounts and you'll rapidly realise it's not that easy. Companies give a wide range of profit figures, from operating profit to net income. So why are there so many, and which is the most important?

Gross profits and margins

Here I will focus on non-financial firms, as banks report somewhat differently to other firms. At the heart of both a corner shop and a big multinational retail business is one principle buy products cheaply, then sell them on for more. This is where gross profit margins and mark ups come in.

If a firm buys in goods for £8 each and sells them for £10, it has marked up each one by £2, or 25% ((£2/£8) x 100%). The gross margin the profit of £2, divided by sales as a percentage is 20% ((£2/£10) x 100%). There are two things to watch for here.

Firstly, if a firm cannot make a profit even at this level, I'm not interested it may occasionally mean missing out on the start of a spectacular growth story, but as far as I'm concerned, it's just too risky. Secondly, watch for any sudden drop in mark up or margin it's a warning sign that either sales prices are being cut to maintain volumes, or input costs are rising. Neither trend is sustainable for long.

Operating profits and margins

Operating profit is gross profit after overheads. It's a key number in sectors such as food retail, where the margin per item is low, but sales volumes are very high. This means that even a small slip in the operating profit margin can have a huge impact on overall profits.

For example, imagine a food retailer has an operating profit margin (operating profit divided into sales as a percentage) of 5%, and £100m in sales. Operating profit is £5m. If the operating margin slips by just 0.5% (due to rising staff costs, say), profit falls by 10% ((£0.5m/£5m) x 100%). If, on the other hand, a firm of luxury car makers usually delivers an operating margin of 20% on £100m sales, the same 0.5% slip in the margin cuts operating profits from £20m to £19.5m, a drop of only 2.5% ((£0.5m/£20m) x 100%).

Operating margins matter because they represent profit the business has made after deducting direct (eg, purchasing) and indirect (eg, heat, light and salaries) running costs. The cost of actually financing the business and paying the tax man are not included here. Operating profit is also known as PBIT (profits before interest and tax) and EBIT (earnings before interest and tax). So why are analysts often still unhappy with it?

Ebita and Ebitda

There's one big drawback to operating profit it includes a deduction for depreciation and amortisation of a firm's long-term assets. Under accounting rules, the directors estimate the useful lives of all the firm's assets and spread the initial cost over that time period. So if a piece of plant machinery costs £20m and is expected to last ten years, the annual depreciation charge (in Britain we "depreciate" stuff you can kick and "amortise" stuff you can't, such as brands) is £2m (£20m/10).

If this all sounds a little subjective (who says ten years is correct?), that's because it is. So some analysts like to remove theses charges altogether hence, earnings before interest, tax, depreciation and amortisation (EBITDA).

But watch out. Directors in, for instance, the telecoms sector might like to be measured on EBITDA growth because it allows them to borrow heavily to invest in new fixed assets (ie, expand a business using huge amounts of debt). The justification is that growth is all that matters, and you worry about profits once you've bagged market share. The trouble is this is one small step away from the type of disastrous 'growth at any price' strategy that sank firms such as Marconi.

Net earnings and EPS

Last we come to profit for the financial year (a.k.a net profit). This number comes after all costs and the dividend have been deducted, and it's the one that goes into the oft-quoted earnings per share (EPS) figure. So if a firm makes £100m profit for the year and it has 200 million ordinary shares in issue, then EPS is 50p (£100m/200m).

But just because a number is widely quoted doesn't make it reliable. For one, EPS is stated after all costs have been deducted, subjective or otherwise. And there are two versions the simple one and the diluted version, that accounts for events that could create more shares, such as the conversion of debt into equity.

So what is the best number to use?

Each figure has its strengths and weaknesses. So you should do two things. First, calculate as many of the above margins as possible, then watch out for inconsistencies or changes that the directors have not explained. Secondly, calculate cash flow per share as a back up.

A big mismatch between earnings and cash flow is a red flag. Also, look out for bosses who are keen to highlight a specific number. A rising profits trend over several years is the Holy Grail for most directors. It maximises their pay packets (which are usually linked in some way to profits) and their chances of moving onto a bigger firm (along with a bigger pay packet). So they will try to draw your attention to the most flattering profits figure available.

A classic is "profits before exceptional (or one-off) items". These items will usually be costs, perhaps for a reorganisation, restructuring or a write-down of assets. But many firms are now in a constant state of flux where restructuring is the norm, so there may be nothing very "exceptional" about these costs. So be particularly wary of any number the directors seem overly anxious for you to focus on.