Gross profit and EBITDA (earnings before interest, taxes, depreciation and amortization) show the earnings of a company. However, the two metrics calculate profit in different ways.
Gross Profit
Gross profit is the income earned by a company after deducting the direct costs of producing its products.
Gross profit measures how well a company generates profit from their direct labor and direct materials. Gross profit does not include non-production costs such as costs for the corporate office. Only the revenue and costs of the production facility are included in gross profit.
When analyzing an income statement, gross profit is calculated by the following:
Gross profit = Revenue – Cost of Goods Sold
Revenue is the total amount of income earned from sales in a period. Revenue is also be called net sales because discounts and deductions from returned merchandise may have been deducted. Revenue is considered the top line earnings number for a company since it’s located at the top of the income statement.
Cost of goods sold or COGS is the direct costs associated with producing goods. Some of the costs included in gross profit include:
- Direct materials
- Direct labor
- Equipment costs involved in production
- Utilities for the production facility
Example of Gross Profit
Below is a portion of the income statement for JC Penney Company Inc. (JCP) as of May 5, 2018.
- Total revenue was $2.67 billion, highlighted in green.
- COGS is below revenue coming in at $1.7 billion.
- Gross profit was $970 million for the period.
As we can see from the example, gross profit does not include operating expenses such as overhead. Gross profit also doesn’t include, interest, taxes, depreciation, and amortization. As a result, gross profit is effective if an investor wants to analyze the financial performance of revenue from production, and management’s ability to manage the costs involved in production. However, if the goal is to analyze operating performance while including operating expenses, EBITDA is a better financial metric.
EBITDA
EBITDA is one indicator of a company’s financial performance and is used as a proxy for the earning potential of a business. EBITDA strips out the cost of debt capital and its tax effects by adding back interest and taxes to earnings. EBITDA also removes depreciation and amortization, a non-cash expense, from earnings. Also, EBITDA helps to show the operating performance of a company before taking into account the capital structure such as debt financing.
EBITDA can be used to analyze and compare profitability among companies and industries as it eliminates the effects of financing and accounting decisions. EBITDA can be calculated by the following formula:
EBITDA = Operating Income + Depreciation and Amortization
Operating income is a company’s profit after subtracting operating expenses or the costs of running the daily business. Operating income helps investors separate out the earnings for the company’s operating performance by excluding interest and taxes.
Example of EBITDA
Below is the same income statement from our gross profit example for JC Penney Company Inc. (JCP) as of May 5, 2018.
- Operating income was $3 million…