The following is a brief scenario that might sound familiar to many new investors. You are starting to evaluate a company’s financial statements to determine whether or not you think that company will be a good investment choice. You know that evaluating financial statements is a very good decision to make as an investor! However, in all of your evaluation, you run across a problem. As you are reading about the company’s financial history, you find that there are some finance terms that simply don’t make sense to you. You thought you knew the difference between a company’s net income and its gross profit, but the more you think about it, the terms start to become hazy. What do you do?
We should start by saying that for many new investors – or even experienced investors who just don’t spend their days thinking about financial statements – this is a very common mistake to make. For many of us, the terms profit and income are typically used interchangeably. However, in finance, these terms can be used in several very different and specific ways, which can change the way we think about a company. By learning these definitions, or at least keeping a note handy for when you are analyzing financial statements, you might be better able to clue yourself into what the statements really mean about the company you have chosen to analyze.
For the sake of this article, we will start by explaining the concept of income. The term ‘income’ usually refers to any positive flow of money into a company. These are usually called positive cash flows. While the definitions of income and cash flows seem simple, they can be further broken down into the concept of net income, which is another frequently used financial term. Net income – which is also called net profit – reflects the number that remains for a company after both positive and negative cash flows are taken into consideration. So, if you’re keeping score: the concept of income is pretty simple while the concept of net income is much more complex.
Before you hit that “bottom line” of net income and before you factor in every single cash flow, you are likely to see two other terms in a company’s financial statements. The first of these two terms is ‘gross profit’. Gross profit is a number that reflects the money that a company has after it pays to produce the goods that it sells. In other terms, to find a company’s gross profit, you would find its revenue and subtract the cost of the goods sold from that number. This means that gross profit is an important number if you are looking to find out how much a company is spending on labor and raw materials.
After you see the term gross profit, you might come across a company’s ‘operating profit’. This term takes not only the cost of producing goods (more commonly called the cost of goods sold) into account, but also fixed cost expenses, like a company’s rent or insurance. Next, it subtracts variable expenses like shipping costs and the depreciation of assets that it already owns. Basically, if an expense is necessary to the functioning of the business, it is included in a company’s operating profit. As investors, this term would be useful to us in order to better understand a business in its entirety – because anything that helps the business function is factored in.
Finally, this takes us back to net income – or net profit – which includes the most factors of all of these three terms. As we mentioned before, this number reflects every single cash flow that the company faced over a year. It includes all of the items that were calculated into the operating profit, and then subtracts taxes and one-time purchases (like big equipment purchases). For us as investors, this number is the one that we will primarily focus on, because it will indicate the company’s ability to generate money for its shareholders.
As you can see, these terms are not extremely straightforward and it is no surprise that many people have difficulty trying to interpret financial statements. However, by recognizing the key terms that you should be looking for and knowing what they mean relative to a company’s business, you could ultimately give yourself a lot more insight into a company’s potential for success!