EFA (13): Profit

Profit lies at the heart of market economies. But what exactly is profit and how is it calculated? This is the subject of the 13th item in our Economics for Amateurs (EFA) series. You can find this series here every Monday.

According to traditional economic theory, profit maximization is the main goal of firms, although they may have other goals, such as maximizing growth.

For an individual product, profit is the difference between the selling price and the cost of production. The profit margin is calculated by expressing the profit as a percentage of the price. Profitability tends to fall in a recession. The opposite of a profit is a loss.

For a firm, profits are the difference between total sales revenue (also called "turnover") and total costs. A company's profits in a particular time period are recorded in its profit and loss account (P&L account; US: "profit and loss statement" or "income statement").

In the financial media, a company's profits are usually referred to as its "earnings", "net income" or simply "net". Companies are often said to "post" rather than "announce" their profits: "YZC posted a 20 per cent fall in earnings." If a company believes that its profits are likely to be lower than it had said in the past, it may issue a profit warning.

There are many ways in which profit figures can be calculated. For example, companies may refer to their pre-tax profits or their post-tax profits. They may also talk about their operating profits, which refers only to profits from normal trading activities (excluding, for example, the effects of buying or selling other companies).

Other important measures of profits are a company's EBIT (earnings before interest and taxes) and its EBITDA (earnings before interest, taxes, depreciation and amortization).

A key financial indicator is a company's earnings per share (EPS), which is the level of post-tax earnings divided by the number of shares. This gives an idea of the amount of profits potentially available to shareholders.

Distributed earnings are those profits that are actually given to shareholders in the form of dividends; retained earningsare kept within the company, for example, to finance future investment.

Another important financial indicator is a company's price-earnings (P/E) ratio. This is calculated by dividing the share price by the earnings per share. Generally, the higher the P/E ratio, the more optimistic investors are about the company's future profitability.