Revenue, gross margin, EBITDA, EBIT, net profit. You’ve probably already heard this business jargon. The question is, do you really understand what they all mean and why they are used? Let’s break it down.
Revenue, gross margin, EBITDA, EBIT and net profit are financial metrics that show the profitability of a company, the ability to earn profits from its sales or operations. You can break them down like a waterfall starting from revenue and deducting costs to reach all the different levels of profitability (Figure 1).
Figure 1: Revenue Breakdown
It all starts with revenue, also referred to as income or earnings. It is basically the total amount of money that comes in from selling your products or services. It is a metric that is often used to compare the size of a company, and all the next financial terms can be put in proportion to it.
💡 Revenue = Income from selling goods and services
Next in the waterfall comes gross margin, also called gross profit. It is equal to revenue minus all costs directly related to producing your products or providing your services. These costs are called your cost of goods sold (COGS). For manufacturing businesses, it includes costs related to direct labour, raw materials, packaging, storage, depreciation of machinery and other factory overheads. For service businesses, the COGS includes salary, payroll taxes and other benefits for people who generate billable hours directly related to the service provided. For retail and wholesale businesses, the COGS equals the cost to purchase the merchandise or goods sold.
Gross margin is often put in proportion to revenue as gross margin percentage. To be equally profitable, a company with a lower gross margin percentage has to earn more revenue than a company with a higher gross margin percentage if they have the same amount of remaining expenses. For example, to end up with the same amount of profit, a manufacturer of milk, who typically has a low gross margin percentage will need a much higher revenue than a manufacturer of jewellery, who typically has a high gross margin percentage.
💡 Gross Margin = Revenue - Cost of Goods Sold (COGS)
💡 Gross Margin Percentage = Gross Margin / Revenue
Further down the waterfall comes EBITDA, which stands for Earnings Before Interest, Taxes, Depreciation and Amortization. It is calculated by deducting all operating expenses from gross margin except for the operating expenses related to depreciation and amortization.
EBITDA gives the profit from a company’s daily operations without looking at the costs related to investments in property, plant and equipment (depreciation and amortization) and without looking at the cost of financing (interest). It just looks at how profitable a company is based on its daily operations. This makes EBITDA the perfect metric to compare profitability between companies and industries.
💡 EBITDA = Revenue - COGS - Operating expenses (excl. depreciation and amortization)
After EBITDA we arrive at EBIT, which stands for Earnings Before Interest and Taxes. It is simply calculated as EBITDA minus depreciation and amortization. It is also called the operating profit or, simply put, the profit a company makes from its daily operations. Interest on loans or earnings on financial investments are not taken into account as they do not relate to the company’s daily operations.
💡 EBIT = EBITDA - Depreciation - Amortization
💡 EBIT = Revenue - COGS - Operating expenses
Lastly, we arrive at the company’s net profit, also referred to as the bottom line or net income. Net profit is equal to EBIT minus interest and taxes. It is the amount of money a company has left after deducting all costs from its revenue. The net profit can be reinvested into the company or can be paid out as dividends to shareholders.
💡 Net Profit = EBIT - Interest - Taxes
💡 Net Profit = Revenue - All costs
Congrats! Now you can join any conversation related to profitability. Go and see how these figures look in practice.