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“In this video. We re going to take a look at profits investors like to to buy firms. The make profits analysts talk about profits newspapers websites talk about hunting 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 and the trick is to realize that 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 half way 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 pocket 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 have 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 a call cost of sales now. Let s say here that s sixty meaning if we take that away that the balance is forty now cost of sales that s the direct cost of making sales. So the 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 bent. 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 a hundred on the direct cost of selling at a sixty. My gross profit. He s 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 sandwich is four 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 percent.
Which sounds pretty healthy you d be happy with that so every time you make a sale you re getting a 40 percent profit margin on it. Except that there s something missing that was quite a lot missing not about overheads not about the fact that if your tesco selling sandwiches. It doesn t just cost you a packet a sound. 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 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 percent 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 businesses 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 ebit 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 ebit. Or the p.
Bit or a bit margin them in this so quite a useful figure in the food retail sector. Now let s watch that like a hawk. It would only be five six at a pinch 7. And much lower 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 varies 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 again when you re saying. What is profit. It is possible to put a name on the 25 there and the 20.
They re not surprisingly if the 5 is tax the 25 is known as profit before tax. Very offshore 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 divided 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 payout 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. And if you re an income investor looking for regular income. That s quite important because you want the 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 e bit or p. Bit margin or they re talking about the net figure after interest in tax and there s one more there s one particular figure. The 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 eat.
It da the d. And the a so earnings before interest in 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.
1. 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 lan divide its cost over say. 10 years and then charge each year s profits with the tenth 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 families 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 the less its last create a charge against profits to reflect that which essentially is down 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 its before you worry about tax policy.
Which frankly is 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 a 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 ii bit da not perfect. But it s a profit number to ” ..
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