Various forms of profit

Last updated: 02.03.2016

Although the profit appears to be unique and comparable term, it is entirely NOT the case. This series of articles discusses possible profit forms - from the perspective of financial accounting, management accounting, tax world or forms profits, which are commonly used in the corporate world (EBIT, EBITDA, Net income etc.).

The series concludes in trying to carry out a reconciliation of most of these profit forms. It is necessary to mention that certain simplifying assumptions were necessary, because some terms are either not fully comparable and or not based on generally binding definitions.



Profit

Profit is generally defined as a difference between income and expenses. It is one of the most common business objectives, a kind of reward for risk and the key measure of success in corporate life.

However, there are many different forms of profit which greatly limits its comparability. Above all, it is necessary to distinguish:



Difference between profit and cash-flow

Profit is usually not equal to cash flow because profit is defined as the difference between income and expenses, while cash flow as the difference between receipts and expenditures.

Accounting profit is the final line in the income statement, while cash flow is the final line in the statement of cash flows.

 

Income is formed by monetary benefits generated from entity´s economic activities. 

Receipts represent inflow of cash (either cash in hand or to a bank account).

The differences between income and receipts result for example from irrecoverable debts (e.g. the income is recognized at the time of delivery, but the customer still has not paid).

 

Expenses represent consumption of inputs (material, labor etc.) incurred in order to generate income.

Expenditures represent outflow of cash (either cash in hand or from a bank account).

Differences between costs and expenses arise from, for example, purchases of fixed assets (expenditure is incurred at the moment of purchase, but depreciation gradually throughout the lifetime of assets) or purchases included in the value of inventory ​​and become costs at the moment of their sale.

More examples can be found in the article Difference between expenses and expenditures.


Distinction between economic and accounting profit

The general definition is valid for both economic and accounting profit: income - expenses

But the terms differ in:



Economic profit

Economic profit: income - explicit and implicit costs

 

It is a concept arising from general economic theory and its purpose is to evaluate the success of the company.

The difference between the economic and accounting profit is described in this article.


Accounting profit

Accounting profit = income - explicit costs

It is a term defined by accounting standards, rules or national legislation used for the purpose of preparing financial statements or possibly tax returns.

The difference between economic and accounting profit is described in this article.

Accounting profit has the following disadvantages.



Explicit costs

Explicit costs are costs that are really incurred by the entity.

Opposite to explicit costs are implicit (opportunity) costs.


Opportunity costs / Implicit costs

Opportunity cost (also called also implicit costs) is the highest possible amount that could be obtained if different alternative would have been adopted (e.g. rent income can be opportunity costs to using the factory premises for manufacturing).

Opposite to implicit (opportunity) costs are explicit costs.



Disadvantages of accounting profit

Profit as a basic profitability indicator used by companies has the following drawbacks:

  • profit does not equal net inflow of money, costs  do not equal expenditures and incomes do not equal receipts
  • profit includes the results of operations that are ad-hoc and will not be repeated in the future
  • various methodologies particularly in the area of:
    • depreciation and amortization
    • impairment
    • provisions
    • accruals
    • valuation
  • different rates of taxation in various countries
  • different accounting standards (IFRS, US GAAP etc.) can treat issues very differently
  • profit is easy to manipulate (so called "window dressing") - e.g. by using different methodologies and their changes, delays in issuing documents

 

These facts make profit less comparable mainly between different entities, but also during comparisons in a time series.

Therefore, it is advisable to see the profit in the context of other indicators such as gross margin, total sales, cash flow, financial analysis ratios etc.


Tax profit

Tax profit is profit serving as the basis for calculating income tax under the provisions applicable tax law.

Tax profit calculation is usually based on the accounting profit that is transformed to tax base.



Categories of profit in IFRS / IAS

Profit (or loss)

  • income   minus
  • expenses

→  excluding other comprehensive income and expenses (i.e. Other comprehensive income) (20)

 

Other comprehensive income

  • incomes not included in the profit and loss   minus
  • expenses not included in the profit and loss

→ it is actually the change in equity during the reporting period that does not arise from transactions with owners (20) (e.g. revaluation of assets in accordance with IAS 16 and IAS 38)

 

Total comprehensive income:

  • profit (or loss)
  • other comprehensive income (20)

 

In accordance with IAS 1, total comprehensive income must be divided into:

  • the part attributable to the owners (i.e. owners having control over the company)
  • the part attributable to non-controlling interest (minority shareholders) (20)

 

In accordance with IFRS 5, total comprehensive income must be divided into:

  • profit/loss from continued operations
  • profit/loss from discontinued operations (certain part of the entity or activity that either has been disposed of or is held for sale and meets the conditions set out in IFRS 5) (21)

Forms of accounting profit used in practice

Above in other articles were mentioned forms of profit that are somehow clearly defined. Nevertheless, the economic world is fond of other indicators and some of them can be usually found in the reporting system of nearly any company. They are often not based on any GAAP (not mentioned even in IFRS) and often do not even appear directly in the financial statements because they are used for analytical purposes.

These are the indicators of:

 

Their biggest handicap is the fact that some of them are more or less defined solely on the basis of unwritten rules and do not have any binding and direct regulation (I´m at least so far convinced about it). Therefore, universally valid methodology that determines what items shall be included is missing and it causes problems with comparability.



Operating income / Operating profit

Operating income is the profit/loss from ordinary operations of the company without:

  • interest expense (i.e. cost of debt)
  • income tax
  • incomes and expenses from non-operational activity (i.e. Non-operating result), which is the result of other than ordinary activities.
  • possibly also profit/loss from discontinued operations (defined in IFRS, other GAAPs may not use this concept)

It's usually EBIT less the income from investments (e.g. dividends). But if the company´s core business is related to investment activity, these incomes can form part of Operating income.

 

Operating income is defined by SEC (US Securities and Exchange Commission), its definition, therefore, has the exact wording. SEC also mentions that Operating income is not directly comparable to EBIT or EBITDA. (19) Therefore, above mentioned comparison with EBIT should be considered only as indicative.

However, in practice, it is unfortunately common that the terms EBIT/PBIT and Operating income are used interchangeably or are considered synonymous.


EBITDA / PBITDA

EBITDA (PBITDA) is the total profit/loss without:

  • interest expense (i.e. cost of debt)
  • income tax
  • depreciation and amortization (i.e. write-downs of intangible assets)
  • possibly also profit/loss from discontinued operations (defined in IFRS, other GAAPs may not use this concept)

EBITDA usually also includes so-called Non-operating result, which is the result of other than normal operating activities. Non-operating result includes, for example, investment income or dividends, if such activity is not the core activity of the company.

Compared to EBIT, EBITDA does not include depreciation and amortization and it therefore enables greater comparability of results between companies with different volume of long-term assets. EBITDA also does not contain interest and income taxes (as well as EBIT) and as such it enables good comparison between companies with different financing structure and different tax rates (i.e. companies in different countries).

In practice is almost exclusively used abbreviation EBITDA (not PBITDA).



EBIT / PBIT

EBIT (PBIT) is the total profit/loss without:

  • interest expense (i.e. cost of debt)
  • income tax
  • possibly also profit/loss from discontinued operations (defined in IFRS, other GAAPs may not use this concept)

 

EBIT usually also includes so-called Non-operating result, which is the result of other than normal operating activities. Non-operating result includes, for example, investment income or dividends, if such activity is not the core activity of the company.

 

EBIT is therefore EBITDA, after the inclusion of depreciation and amortization (i.e. depreciation of intangible assets).

 

Because EBIT does not contain interest and income taxes, it enables good comparison between companies with different financing and different tax rates (i.e. companies in different countries). Unlike EBITDA, however, EBIT does not enable comparison between companies with different volume of long-term assets.

In practice is almost exclusively used abbreviation EBIT (not PBIT).


EBT / PBT

EBT (PBT) is the total profit/loss without:

  • income tax
  • possibly also profit/loss from discontinued operations (defined in IFRS, other GAAPs may not use this concept)

 

EBT thus equals indicators:

  • EBIT after including interest expense (i.e. cost of debt)
  • EAT (PAT) after removing the income tax


EAT / PAT

EAT (PAT) is the total profit/loss after tax from continuing operations, OR more often the total profit/loss after tax (i.e. including the profit/loss from discontinued operations).

 

It is therefore EBT with income tax or possibly also profit/loss from discontinued operations. Continuing or discontinued operations are concepts are based on IFRS and other GAAPs may not use it.

In practice, more widely used abbreviation is PAT (not EAT).


Net income

Net income is the total profit/loss (that is, including net profit/loss from discontinued operations), sometimes shown after deduction of profit/loss attributable to non-controlling interest (minority interest).



EAC

EAC's is total profit/loss after tax, after allocation to statutory reserve and dividend payments to the owners of preferred shares. (18)

EAC = Earnings Available for Common stockholders


NOPAT

There are many definitions of NOPAT, therefore the use of this indicator is quite misleading.

Common definition is: profit/loss on ordinary activities after taxation without taxed interest expense (i.e.  interest expense is adjusted for the effect of tax savings resulting from the interest expense).



Reconciliation of Operating income, EBITDA, EBIT (PBIT), EBT (PBT), EAT (PAT), Net income and EAC to IFRS

At the outset, it is necessary to mention that the below stated reconciliation is neither official nor binding and some terms are in fact not fully comparable (e.g. Operating income and EBIT/EBITDA).

Although the profit forms mentioned below are very favourite, they mostly lack any public normative definition. They are not regulated also by IFRS and as the result, the reconciliation may not always fully fit (especially the concept of dis/continued operations).

This reconciliation is therefore only indicative and not binding.

 

However, the reconciliation may simply look like this:

 

Cost of debt may include not only interest on loans, but also:

  • interest from financial leasing
  • various forms of bank or leasing fees etc.

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