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 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
- 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 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
- Operating income was $3 million, highlighted in blue.
- Depreciation was $141 million, but the $3 million in operating income includes subtracting the $141 million in depreciation. As a result, depreciation and amortization need to be added back into the operating income number during the EBITDA calculation.
- EBITDA was $144 million for the period or $141 million + $3 million.
- We can see that interest expenses and taxes are not included in operating income, highlighted in green, but instead, are included in net income or the bottom line.
The above example shows that the EBITDA figure of $144 million was quite different from the $970 million gross profit figure during the same period. One metric is not better than the other. Instead, they both show the profit of the company in different ways by stripping out different items. Operating expenses are removed with gross profit. Non-cash items like depreciation, as well as taxes and the capital structure or financing, are stripped out with EBITDA.
Investors and analysts might want to break down the different profit metrics to peer into the workings of a company. EBITDA helps to strip out management decisions or possible manipulation by removing debt financing for example, while gross profit can help analyze the production efficiency of a retailer that might have a lot of cost of goods sold as in the case of JC Penney.
Since depreciation is not captured in EBITDA, it has some drawbacks when analyzing a company with a significant amount of fixed assets. For example, an oil company might have large investments in property, plant, and equipment. As a result, the depreciation expense would be quite large, and with depreciation expenses removed, the earnings of the company would be inflated.
EBITDA can also be calculated by taking net income and adding back interest, taxes, depreciation, and amortization. Please bear in mind that each EBITDA formula can result in different profit numbers. The difference between the two EBITDA calculations may be explained by the sale of a large piece of equipment or investment profits, but if that inclusion is not specified explicitly, this figure can be misleading. As a result, both EBITDA formulas might yield slightly different results, and investors should be aware of what components make up the difference.
For more on analyzing the profitability of a company, please read "How Do Gross Profit and Gross Margin Differ?"