The income statement is a summation of different kinds of profits with each having a different interpretation and application. Let us look at some key profitability metrics.

Gross profit = Revenues - cost of goods sold

Gross profits represent the difference between total sales and the cost of producing the goods or services you sell. It is a barometer of the core production or service activity and becomes a guide to pricing the product or service appropriately and also gives you an idea of how much leeway the business when it comes to pricing. The gross profit margin (GPM) is normally more relevant than the absolute number as it gives a relative analytical picture. This is a useful input when it comes to pricing decisions by the company.

Operating profit = Gross profit - operating expenses

Cost of goods sold refers to the costs that are directly attributable to the output. But there are other fixed costs like rent, salaries, office expenses, maintenance costs and depreciation which are also business expenses. When you deduct these other operating expenses from Gross Profit you get the Operating profit or (EBIT). Here again, the OPM has a lot more importance and impact than the absolute number. This is one of the most important components of the income statement as it tells you how much of profit is generated from core operations of the business. Quite often, even loss making companies have operating profits, which forms the basis for your capital allocation decisions.

Net profit = Operating profit – interest - taxes

This is called the “bottom line” because that is what shareholders earn after paying out all costs of the business. Some of the most important ratios like the net profit margins; ROE and ROA are based on this Net Profit only.

An understanding of the subdivision of profits is the key to understanding where the profit is coming from and what should be the analytical strategy in response. In fact the efficacy of most of the ratio analysis that we do as analysts is largely depending on an understanding of the breakdown of the profit and loss account.