Having an understanding of key financial terms is crucial to interpreting the performance of your business and allowing for planning which doesn’t endanger your business in its next phase.
From apparent extensive profits and losses to more modest returns, single items on balance sheets often fail to provide the full story. This means that small businesses must review their performance in several ways.
From how much money the business made it total, how much it was left with to what would have happened had there not been, for example, unexpected expenses, small businesses must fully acknowledge each item to understand how the business performed.
Each of these items are referred to in different ways, namely Gross Profit, Net Profit and EBITDA. In this article we explain them to ensure that you understand what is being referred to when reviewing your business year…
Gross profit is the sum of sales in a given period minus the cost of the goods sold in the same period. The cost of goods sold is calculated by totalling expenses, namely those which go directly into producing the products and services themselves such as manufacturing, buying, receiving and storing. This does not include fixed costs, generally items such as salaries, insurance, rent and office expenses, which have a far less immediate financial relationship to your product and the profit it generates.
Gross profit provides a simplified picture of the profitability of your products and services. It is a useful figure for an established business trialling a new product, where fixed expenses already accounted for within the larger company, therefore are a less important indicator of the direct profitability of adding the new product itself.
In terms of business process improvement, gross profit figures can also provide an insight into how effectively a management team control the creation of products and services. For instance, looking at gross profit vs profit following deduction of fixed costs you can drive cost-saving innovations and changes in both the manufacturing and sales processes.
EBITDA, or ‘earnings before interest, taxes, depreciation and amortisation’, is a way of excluding non-operating activities from your figures, allowing you to focus in on the specific profitability of your business operations.
By removing such figures as interest, tax, accounting, depreciation costs or irregular/unexpected costs, for example legal fees which are non-recurring or the depreciating cost of new machinery, from your costs, EBITDA provides an indicator of how successful a revenue model is before highly variable costs cloud the picture.
Similarly, EBITDA is helpful for investors, especially from larger firms, who may have different tax and depreciation arrangements to a business they wish to acquire. EBITDA provides investors with a simplified indicator of a business’ profitability, by removing factors potentially irrelevant to their own existing operating model.
Net profit is often referred to as the ‘bottom line’. It concerns the total revenue of a business minus their total expenses, and provides a more absolute figure than the somewhat more nuanced stats generated by EBITDA and gross profit figures.
When pitching your business to outside investors, net profit is an important figure. Several years of a positive net profit suggests that your gross profit is substantial and operating costs are efficient. This will increase your investment potential due to a reduced risk of a low return, or even loss, on investment.
EBITDA, gross and net profit all offer different perspectives on the success of your business, from particularly profitable products to the overall health of your business once larger, more fixed costs are accounted for.
Understanding each, and their implications for your business’ short and long term objectives, is imperative in ensuring your long term security and prosperity.
We are specialist online small business accountants with offices in both London and Brighton offering tax, accounting and business support to small businesses. Our ACA and ACCA qualified accountants work with our clients to keep the organised and compliant while our business consultants help drive efficiency, growth and profitability.
If you need help understanding your balance sheet or making it more efficient and/or appealing to investors then talk to us today.