What is profit? - MoneyWeek Investment Tutorials

so in this video we're going to take a look at profits investors like to buy firms that make profits analysts talk about profits newspapers websites talk about hunting down firms with decent profit growth and potential but actually let's ask in today's video a simple question what exactly do you mean by profits very important when a firm of directors says we are profitable what does that actually mean the trick is to realize there are about four or five different ways a firm can make a profit and it's important as an investor to know which is which okay so let's lay out a simple profit and loss account now the profit and loss account appears in the annual financial statements about halfway through it's one of the three primary statements and it's the one you hit first so it's in front of the so-called balance sheet and the cash flow statement so let's take a very simple profit and loss account i'm going to simplify it slightly and see how many different ways there are to talk about profit okay so the first figure in the profit and loss account right at the top is sales and i'll use some fictitious numbers to keep it nice and simple so we can focus on the jargon so sales or turnover let's say 100 pounds or just 100. right that's not a profit figure that's just what does the company sell vital because you sell nothing you can't make any profits so the sales figure matters but the first profit figure is a little bit further down next what is it costing us to make those sales people who put accounts together talk about the cost of sales so in a profit and loss account the sales figures nice big positive number at the top and just below it there's a deduction for what i call cost of sales now let's say here that's 60 meaning if we take that away that the balance is 40. now cost of sales that's the direct cost of making sales so at a magazine for example that would be things like your publishing costs and your print and packaging costs in other words the costs that vary with sales if you're not selling any magazines you don't print them some costs don't vary with sales light electricity and staff salaries you have to pay those anyway but cost of sales captures the costs that do vary with sales sometimes known as variable costs and here's our first profit figure on the back of an envelope a trader would say if i sell something for 100 and the direct cost of selling it at 60 my gross profit is 40. so there's the first profit figure if a board of directors talk about gross profit they mean the profit that the company makes from sales minus direct cost of sales so the tesco what you sell your sandwiches for minus the cost of the sandwiches themselves in a nice little packet from a supplier so gross profit 40 and sometimes you'll hear people talk about the gross margin and they'll give a percentage and just out of interest that is the margin or the gross margin is simply that number 40 over that one 100 as a percentage so you could say our gross margin is 40 which sounds pretty healthy you'd be happy with that um so every time you make a sale you're getting a 40 profit margin on it except that there's something missing that was quite a lot missing what about overheads what about the fact that if you're tesco selling sandwiches it doesn't just cost you a packet of sand we use from a supplier to be able to make a sale what about staff costs what about the buildings you're in what about electricity gas well they come in as what some accountants call overheads i'm going to call them operating costs and let's make those 10 so the result for keeping this running total of our profit is 30 and that's called an operating profit and indeed if you wanted to you could talk about an operating profit margin this time 30 over 100 so the operating profit over the sales figure as a percentage so the margin here has dropped to 30 and the difference between that margin the gross margin and this one the operating profit margin is whatever these are operating costs overheads and those are important as a business as a supermarket you can't ignore them so a lot of analysts think this is a better number the gross margin is fine but actually a more comprehensive view of how profitable the business is is operating profit or the operating margin and watch out for this analysts and commentators have different words for the same number so for example if you've ever seen p bit or e bit is that number that's profit before interest and tax because actually we haven't deducted any financing costs yet for the loans that are paying for this business and we haven't taken off the tax charge yet either or earnings before interest and tax so if an analyst says p-bit or e-bit or the p-bit or e-bit margin they mean this so quite a useful figure um in the food retail sector analysts watch that like a hawk it would only be five six at a pinch seven percent so much lower than this number and if it changes analysts get very jumpy about what's going to happen to overall profitability for that kind of business so that's a fairly key number but it's not the end of the story what about interest charges what about the fact that this business may have loans outstanding and those have got to be paid for so let's make those five bringing our total down to 25 and what about tax companies pay tax on their profits the rate there is depending on how big they are small companies pay a little bit less than large ones obviously and that could account for let's say another five of those profits bringing us down to let's say 20. now um again when you're saying what is profit it is possible to put a name on the 25 there and the 20 there not surprisingly if the five is tax the 25 is known as profit before tax very often shortened to pbt and the one after tax is known as profit after tax and that is the profit figure that's used in earnings per share calculations normally so the net profit margin net because it's after virtually all costs including financing charges and tax is not quite as impressive it's not bad it's more like 20 and if you were doing an earnings per share calculation you would take the earnings for the year 20 divide by the number of shares in issue and that would give you your earnings per share figure so profit after tax is also quite an important number and it's quite often used in other calculations now there's one more line to go dividends so the directors know that for the last 12 months they've made a profit of 20. after direct indirect costs interest and tax they might decide to share that out with external shareholders so there will be a line somewhere near the bottom for dividends now how much of this 20 they pay out and how much they keep back and retain in the business for investment is up to the directors but maybe they decide to pay out let's say half the profit for the year and then accountants call the balance quite often what's been retained or the retained profits so there's yet another profit figure the amount that's been kept back in the business to be invested in future years and actually people would look at this and start to say well okay this looks like the directors are paying out half the profit after tax as dividends so in that case the so-called payout ratio that's the amount of profits paid out as a dividend rather than being kept back in the business is half or 50 percent and if you're an income investor looking for regular income that's quite important because you want a firm that pays out a decent proportion of its profits each year if this is you know close to zero then maybe you're looking in the wrong place so the conclusion from all this is there are a number of different profit figures if a company says we make profits of or our margin is you need to understand which number they're talking about did they just say the gross margin that's up here did they talk about the operating profit margin that's pretty key the ebit or p bit margin or they're talking about the net figure after interest and tax and there's one more there's one particular figure that analysts love to use it's called ebit da what's the dar what's going on there well it sounds like some version of this number so it's the operating profit figure but what's happened so if you ever hear someone talking about ebit da the d and the a so earnings before interest and tax and two other things before depreciation and amortization now depreciation and amortization in a nutshell are costs buried in here normally that reflect the wearing out of a company's assets in other words if i buy a delivery van for example as a company and i think i can make sales from it for 10 years before it collapses in a heap i might choose to write off one-tenth of its original cost each year through the profit and loss account the reason for not writing off the entire cost in year one is because i can still use the van to generate sales for another nine years so accountants quite keen on this idea of matching costs and revenues prefer it if you take something like a van divide its cost over say 10 years and then charge each year's profits with the 10th of the cost of the van that's known as depreciation when you do it to an intangible asset like a brand name or a patent or a license to drill for oil or something like that it's called an amortization charge and some analysts think it's a bit dodgy and i can understand their reasoning so you're telling me the directors are allowed to simply decide how long their assets last create a charge against profits to reflect that which essentially is down to their judgment and the answer is yes so some analysts prefer to have the operating profit figure ebit stated before depreciation and amortization in other words they add back the amount they think the company is charged for those two items and that then becomes what some analysts think is a more reliable profit figure it's closer to something cash based it's got fewer subjective almost slightly dubious sounding charges included within it and most importantly it's before you worry about tax policy which frankly has nothing to do with operating a business it's more about tax rules and interest on debt which again you could say the interest i pay on there doesn't have a whole lot to do with the nuts and bolts of my business it just reflects the decision i made about whether i took out a loan to pay for the business in the first place or maybe went to shareholders for capital so ebitda not perfect but it's a profit number to watch out for

Channel: MoneyWeek

Views: 119,165

Keywords: profit, economic, analysis, tutorial, educational, moneyweek, tim, bennett, finance, investment

Id: IQuYnADhuwo

Length: 13min 27sec (807 seconds)

Published: Fri Apr 01 2011