Finance for Entrepreneurs: Understanding Profit

Whenever a business is able to generate revenue from the sale of its products or services, it indicates that the market perceives value. It is an indicator that the business is creating value for its customers. Profit on the other hand is an indicator that the business is also able to capture a portion of that value for itself. Profit is a very attractive term in entrepreneurship. Almost every entrepreneur keeps searching for it. Every investor keeps asking if the firm is making profits. But what are profits and what are the various terms that depict profits. This lesson focuses on understanding the various terms used related to profits.

Profits in general refer to the surplus that the business generates after all expenses are paid for from the revenue generated. There are many levels at which profit is calculated in a Profit / Loss Statement. Here are a few of them:

Gross Profit (GP) = Revenue – Cost of Goods Sold

GP is a reflection of the quality of the product or service of the business. We will look at the power of GP in the next lesson.

Profit before interest, taxes, depreciation and amortization (PBITDA) = Revenue – (All expenses except interest, taxes, depreciation, and amortization)

PBITDA is also called popularly as EBITDA. The word profits is replaced with the word earnings. This refers to all operational profits of the business. If a business makes a fair EBITDA then it shows the ability of the business to keep its overheads and operational costs under control. In many businesses this forms the core of their competence, which is keeping the EBITDA large by running a lean and controlled enterprise.

Profit before interest and taxes (PBIT) = Revenue – (All expenses except interest and taxes)

PBIT is also referred to as EBIT or Earnings Before Interest and Taxes. It is calculated after removing any amortized and / or depreciation items brought from the Balance Sheet as expenses.

Profit before Taxes (PBT) = Revenue – (All expenses except taxes)

PBT is also referred to as EBT or Earnings Before Taxes. It refers to the Net Profit that the business generates. It is also the earnings on which taxes are paid by the business.

Profit After Taxes (PAT) = Revenue – (All expenses and taxes)

This is the profit figure that is left with the enterprise after paying taxes due based on the tax laws in the country of operations. This is the money that the business has created for its owners. It can either pay this money to the shareholders or owners as dividend or it can keep it in the business for further investments.

Retained Profits = Profit After Taxes – Dividends Payable

If the business decides to pay dividends then that amount is deducted from the PAT and whatever remains is moved to the Balance Sheet under ‘Retained Earnings’. It is the money that the business keeps with itself which is actually due to the owners.

All the above terms are used to refer to profits of a business. Try to understand them. Go back to your Profit / Loss Statement and your Balance Sheet and locate these terms in them.

We will look at ‘Gross Profits’ alone in the next lesson as it is more important than the others in the case of an entrepreneur.

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