Gross profit vs. EBITDA: what is more important?

In the realm of financial analysis, understanding a company's profitability is paramount. Two key metrics often used for this purpose are gross profit and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation). While both offer insights into a company's financial health, they reveal profitability from different perspectives. So, which one should you focus on when you invest in stocks? This blog dives deep into the distinctions between gross profit and EBITDA and explores which one might hold greater significance depending on the context.

What is gross profit?

Gross profit, also known as gross margin, is a relatively simple calculation. It represents the profit a company makes after deducting the direct costs of producing goods or services from its revenue. Here's the formula:

• Gross Profit = Revenue - Cost of Goods Sold (COGS)

COGS includes expenses directly tied to production, such as raw materials, labour, and direct overhead costs. By analysing gross profit, you can gauge a company's efficiency in converting raw materials and labour into saleable products. A higher gross profit margin indicates better efficiency in managing production costs.

What is EBITDA?

EBITDA takes the analysis a step further. It reflects a company's operating profitability by considering not only production costs but also certain non-cash expenses. Here's the formula:

• EBITDA = Operating Profit + Depreciation & Amortisation

Operating profit, in simpler terms, is profit after deducting all operating expenses (including COGS) from revenue. Depreciation and amortisation are non-cash expenses that account for the gradual wear and tear of physical assets (depreciation) and the intangible assets (like patents) value reduction over time (amortisation).

Gross Profit vs. EBITDA: understanding the difference

Here's a table summarising the key differences between gross profit and EBITDA:

Gross profit vs. EBITDA: which is more important?

The answer depends on the context and what aspect of profitability you're trying to assess:

• Gross Profit: A valuable metric for understanding a company's ability to manage production costs and pricing strategies. It's particularly relevant for manufacturing or service-based companies where production costs form a significant portion of total expenses.
• EBITDA: Provides a more holistic view of a company's operational profitability by factoring in non-cash expenses. It's often used for comparing companies across different industries as it removes the impact of accounting choices related to depreciation and amortisation. Additionally, EBITDA is closer to a company's actual cash flow generation capacity, making it an attractive metric for financial modelling and valuation purposes.

Conclusion

Both gross profit and EBITDA hold significance when analysing a company's financial health. Gross profit provides insights into production efficiency, while EBITDA offers a broader perspective on operational profitability. The most effective approach is to utilise both metrics in conjunction with other financial data to gain a comprehensive understanding of a company's performance and potential. Remember, financial analysis is like solving a puzzle; each metric adds a piece to the picture, revealing the bigger story. Happy analysis!