Gross Profit vs. EBITDA: An Overview
Gross profit and EBITDA (earnings beforeinterest, taxes, depreciation, and amortization) each show theearnings of a company. However,the two metrics calculate profit in different ways. Investors and analysts may want to look at both profit metrics to gain a better understanding of a company's revenue and how it operates.
Key Takeaways
- Both gross profit and EBITDA are financial metrics that measure a company's profitability by removing different items or costs.
- Gross profit appears on a company's income statement and is the profit a company makes after subtracting the costs associated with making its products or providing its services.
- EBITDA is a measure of a company's profitability that shows earnings before interest, taxes, depreciation, and amortization.
- Investors and analysts can use gross profits to determine how well a company generates profit from its direct labor and direct materials, whereas they can use EBITDA to analyze and compare profitability among companies and industries.
What Is Gross Profit?
Gross profitis the income earned by a company after deductingthe direct costsofproducingits products or providing its services. It measures how wella company generates profit from its direct labor and direct materials.
Gross profit does notinclude non-production costs such as costs for the corporate office. Only the revenueand costs of the company's production facility areincluded in gross profit.
The Formula for Gross Profit
GrossProfit=Revenue−CostofGoodsSold
Revenueis the total amount of income earned from salesin aperiod. Revenue canalso be called net sales because discounts and deductions fromreturned merchandise may have been deducted from it. Revenue is consideredthe top-line earnings numberfor a company sinceit's locatedat the top of the income statement.
Cost of goods sold(COGS)is the direct costs associated with producing goods. Some of the costs included in gross profit are:
- Direct materials
- Direct labor
- Equipment costs involved in production
- Utilities for the production facility
ExampleofGross ProfitCalculation
Below is a portion of theincome statementfor J.C. Penney Company,Inc.(JCP)on May 5,2018.
- Total revenue was$2.67 billion (highlighted in green).
- COGS was $1.71 billion (highlighted in red).
- Gross profit was $960 million for the period.
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As we can see from the example, gross profit does not include operating expenses such asoverhead. It also doesn't include interest, taxes,depreciation, and amortization. Because of this, gross profit is effective if an investor wants to analyze the financial performance of revenue from production andmanagement'sability to manage the costs involved in production. However, if the goal is to analyze operating performance while including operating expenses, EBITDA is a betterfinancial metric.
What Is EBITDA?
EBITDA is one indicator of a company'sfinancial performanceand 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. It also helps to show the operating performance of a companybefore taking into accountthe capital structure, such as debt financing.
Note
EBITDA can be used to analyze and compare profitability among companies and industries, as it eliminates the effects of financing and accounting decisions.
The Formula for EBITDA
EBITDA=OI+Depreciation+Amortizationwhere:
Operating incomeis a company's profitafter subtractingoperating expensesorthe costs of running the daily business. Operating income helpsinvestors separate out the earnings for the company's operating performance by excludinginterest and taxes.
Example of EBITDA Calculation
Let's usethe sameincome statementfrom the gross profit examplefor J.C. Penney above:
- Operating income was $3 million.
- Depreciation was $141 million, but the $3 million in operating incomeincludes subtracting the $141 million in depreciation. As a result, depreciationand amortization needto be added back into the operating income number during the EBITDA calculation.
- EBITDA was $144million for the period ($141 million + $3 million).
We can see that interest expenses and taxes are not included in operating income but instead are included in net income or the bottom line.
Special Considerations
The above examples showthat the EBITDA figure of $144 million was quite different from the $960 milliongross profit figure during the same period.
One metric is not better than the other. Instead, they bothshow the profit of the company in different ways by stripping out different items. Operating expenses areremovedwithgross profit. Non-cash items like depreciation, as well as taxes and the capital structure orfinancing, arestripped out withEBITDA.
EBITDA helps to strip out managementdecisions or possiblemanipulation by removingdebt financing, for example, while gross profit can help analyze the production efficiency of a retailer that might havea lot of cost of goods sold, as in the case of J.C. Penney.
Since depreciation is not captured in EBITDA, it has some drawbacks when analyzing a company with a significantamount offixed assets. Forexample, an oil company might have large investments in property, plant, and equipment. As a result, the depreciation expense would be quite large,andwith depreciation expenses removed, theearnings of the company would be inflated.
Can EBITDA Be Higher Than Gross Profit?
Gross profit should be greater than EBITDA because it does not consider the operating expenses built into the EBITDA calculation. EBITDA and gross profit are designed to measure different things. Gross profit measures how well a company can generate profit from labor and materials, while EBITDA is better for comparison among industry peers.
How Do You Convert Gross Profit to EBITDA?
It is not a matter of converting one to the other since the different calculations measure different things. The EBITDA calculation uses operating income, which is gross profit minus operating expenses, such as overhead.
Why Is EBITDA More Important Than Profit?
It's not necessarily more important, but it is more useful to investors in certain contexts. Gross profit limits analysis to a company's ability to turn labor and materials into profit. EBITDA also takes into account operating performance. EBITDA also has drawbacks, such as inflating earnings for companies with many fixed assets that depreciate.
The Bottom Line
EBITDA and gross profit are different ways that analysts or investors might look at a company. One is not necessarily better than the other since each is designed to measure something different. EBITDA strips interest, taxes, depreciation, and amortization from operating income, while gross profit strips the cost of labor and materials from revenue.
