Which profit figure is the most important?

Profit is vital to any successful business. But there are several ways to measure it. Tim Bennett explains what each one means, and which one you should use.

Profit is vital to any investor. It's the key to share price growth and dividend payouts. And if a company isn't making more money than it spends on a consistent basis, then ultimately it's doomed.

But how do you measure it?

It should be simple. Add up all the sales the company made, take away the costs involved in making those sales, and there you go - that's your profit.

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Yet, thanks largely to accounting rules, firms report a wide range of different figures in their profit and loss account. Each one tells a slightly different version of the story of the firm's activities across the latest financial year.

Here's what the most important ones reveal to an investor about how well a firm is doing.

Gross profit

Starting from the top of the profit and loss account, the first number you hit is sales. That's because it's the most important number the lifeblood of the business. No sales = no profits!

So a basic first check for the health of a firm is to look at which way sales are heading: clearly rising sales are what you're after.

To get to gross profit from here, you deduct the direct cost of making those sales. We're talking about costs that vary with sales. These might include raw materials, or the cost of buying a product from a wholesaler, and direct staff costs (such as bonuses for sales people).

If sales, for example, are £300m and the 'cost of goods sold' is £200m, then gross profit is £100m. That gives a 33% gross margin ((£100m/£300m) x 100%).

You can also express this as mark-up'. This is gross profit as a percentage of cost of sales. So here that's 50% ((£100/£200m) x 100%).

A sudden drop in either of these measures may mean prices are being slashed, or that supplier costs have risen sharply. Both spell trouble.

As an investor, you want to look at both the absolute level of gross profit year-on-year, and how margins (or mark-ups) are changing over time.

Ideally you want to see rising sales, rising gross profit, and a rising margin. For example, if sales are rising, but the margin is falling, then the company may be sacrificing profitability for added sales. That's often a sign that a company's competitive edge is being eroded.

Operating profit

Gross profit is just the first layer of profit. You've accounted for the direct costs the materials that went into creating the product, for example.

Now you need to throw in indirect costs, or overheads'. These are costs that don't tend to vary directly with sales levels, such as back-office salaries and rent, for example.

A decent operating margin means a business makes good money before you take its funding costs into account. (Funding costs include interest paid to banks and dividend payouts.)

But how worried should you be if operating profit drops? It depends.

Say a watchmaker sells 100 watches for £10,000 each at an operating margin of 50%.Overall sales are £1,000,000, and operating profit is £500,000.

A clothing retailer might sell 1,000,000 T-shirts for £10 on an operating margin of 5%. Again, that's £1,000,000 in sales, and £500,000 in operating profit.

But let's say the operating margin for each falls by three percentage points.

Operating profits at the watchmaker fall to £470,000 (100 x £4,700). But the clothing retailer's operating profits fall to £200,000 (1,000,000 x £10 x 0.02).

So operating margins are particularly important to watch in high volume, low margin areas such as clothing and food. That's why analysts watch operating margins at Tesco or Morrisons like a hawk, but are slightly more relaxed when looking at a luxury goods manufacturer.

Exceptional items watch out for these!

Directors argue that shareholders should not fret about one-off, unusual hits to profit.

So, accounting rules allow bad news such as reorganisation costs, a drop in the value of long-term assets, or losses from selling them, to come in below operating profit.

Thus operating profit is, in effect, 'profit before bad stuff'.

You can accept this argument to a point. If a company's underlying business is ticking along nicely, and the cost is genuinely a one-off (closing an under-performing unit, for example), then it may be reasonable to put it aside for the purposes of analysing the business.

But watch out. Many firms restructure all the time just to survive, so there's nothing 'exceptional' about it. The telecoms industry is a classic example of this.

As for 'exceptional' asset write-downs how many of us could borrow £100,000, spend it on a property that then falls in value, and then tell the bank to ignore it as a 'one-off' error?

So, you must use your own judgment as to whether an 'exceptional' item really is a one-off or not, and therefore whether it should be deducted from operating profit or just ignored.

Net profit

Once a company has knocked off financing costs and tax, you hit the profits after tax or 'net' profits line.This is the number from which a firm's directors pay the dividend. It is also the number that goes into the well-publicised earnings per share (EPS) number at the foot of the profit and loss account.

EPS is just the net profit number divided by the number of shares in issue. It is also often a number the directors want you to focus on, so it's important to be a bit sceptical.

In fact, as a rule of thumb, if the directors draw your attention to any particular profit figure, or any other number for that matter (by boxing it out, for example, or highlighting it near the top of the accounts), be especially wary it's likely to be the one that flatters them the most.

On net profit particularly if you are looking to buy an income stock always check the payout ratio. This is the proportion of this year's net profit that has been paid out as dividends.

Say profits are £100m and the annual dividend is £20m - the payout ratio is 20%. All else being equal, the lower the better - too high and payouts may not be maintained, meaning there's less scope for dividend growth.

Retained profit

Once a company has knocked off all its costs, including any dividend that's been paid, you get 'retained' profit. This is what's left over as a buffer for future years. This matters because, subject to accounting tweaks, a firm can pay out cumulative past profits as dividends.

Ebitda - why directors like it, and why you should be sceptical

To finish up, there's one number the analysts like to use, even if it isn't part of a firm's normal profit and loss account.

This is earnings before interest, tax, depreciation and amortisation (ebitda).

The last two terms reflect charges against profits made for the wearing out of long-term, or fixed, assets.For example, if a piece of factory equipment is bought for £1m and is expected to last forten years, each of the next ten profit and loss accounts will be hit with a charge of £100,000.

Analysts like ebitda because these costs are so subjective. Whyten years in the example above? Why notfive or 25? So, getting rid of them makes for a more reliable profit figure.

Taking out interest and tax meanwhile, removes two items that are more to do with how the business is financed and taxed, rather than how profitable it is at its core.

In summary, you'll hear people claim that ebitda is "closer to cash" and therefore a better number than say operating profit or net profit after tax.

But be careful - ebitda also flatters the directors. For a start, ebitda is often linked to director remuneration.As a result, before the credit crunch, telecoms firms, for example, would borrow lots of money (meaning high interest charges) to invest in new network capacity (meaning high depreciation charges), safe in the knowledge that ebitda ignored both. Many grew their companies rapidly using debt, and are now taking big 'exceptional' hits as acquisitions turn sour.

But they're not too worried, because they've had their big pay packets in the meantime. Not so good for their investors though.

What to do

From all of this hopefully you can see that the next time a director says "we made great profits last year" or newspaper headlines scream "profits at XYZ up 20%", your first response should be "yes, but which profit figure are you talking about?".

Each profit figure tells its own story by looking at several of them together you can build up a true picture of how well a firm is doing.

I'll end on a caveat profit isn't everything. Many a profitable firm has gone bust in the past. That's why you also need to understand balance sheets and cash flow statements, topics we cover in otherarticles.

Tim graduated with a history degree from Cambridge University in 1989 and, after a year of travelling, joined the financial services firm Ernst and Young in 1990, qualifying as a chartered accountant in 1994.

He then moved into financial markets training, designing and running a variety of courses at graduate level and beyond for a range of organisations including the Securities and Investment Institute and UBS. He joined MoneyWeek in 2007.