The Profit Ladder: Revenue to Earnings Per Share

The profit ladder is the sequence of profit figures an income statement produces, each with more cost taken off than the rung above it. Revenue less product cost gives gross profit; less operating cost gives earnings before interest, tax, depreciation and amortisation (EBITDA); less depreciation gives earnings before interest and tax (EBIT), also called operating income; less finance cost gives earnings before tax; less tax gives profit after tax; divided by the share count, earnings per share. Each rung answers a different question.

Here is what sits underneath that. Different readers care about different costs, and they are not being difficult about it. Financing is the lender's own claim on the profit, so a lender wants the figure before financing has been taken off. A figure that has already paid the lender says nothing about whether the business could pay. Only what is left after everything can reach a shareholder, so a shareholder wants the final figure. The tax authority wants a figure computed under its own rules and no other. One statement serves all of them by reporting the subtraction at every stage instead of only at the end.

Read in order, the six rungs say what cost is still inside each figure, where each kind of reader stops, and, for a year in which revenue rose while profit fell, exactly where the fall entered.

What is the profit ladder, and why is it a ladder?

A salary slip has this shape, and the shape is already familiar. A monthly slip reports not one number but four: gross pay, then pay after the provident fund deduction, then pay after tax has been withheld, then the amount that actually lands in the bank. Asked what they earn, the person holding that slip has four true answers. The top figure is what the job costs the employer, so the employer quotes that one. A bank assessing them for a home loan looks at a figure in the middle. The bottom one is the money that exists, so the household budget runs on it. Nobody is lying at any stage. Each figure is the honest answer to a different question, and the slip prints all four because the questions all get asked.

A profit ladderThe ordered set of profit figures an income statement reports, each one the figure above it with one more named group of cost taken away. exists for the same reason: there is no single true profit figure, only a sequence of them, each taking off one more kind of cost. Two things make the sequence a ladder rather than a list: the order is fixed, and every rung is defined as the rung above it less one named group of cost. Each rung is built out of the one before, so the order cannot be rearranged and no rung can be skipped. The fixed order lets two people in two different cities pick up two different sets of accounts and mean the same thing by the word EBITDA.

The same six figures drawn to scale show what the staircase above hides. Revenue is not mostly profit. Revenue is mostly cost, and the entire ladder from gross profit downwards lives inside the slice that the first subtraction leaves behind. The coloured band narrows quickly from left to right.

Which lines are income line items, and which are profit line items?

There is a distinction inside the statement that almost nobody points out to a first reader, and missing it causes real confusion later. Some lines on an income statement are recorded. Somebody entered them, from a document: an invoice, a payroll register, a bank advice, a depreciation schedule, a tax computation. The recorded lines are the income line items and the expense line items, and behind each one sits paper. The rungs of the ladder are not like that at all. Gross profit, EBITDA, EBIT, earnings before tax and profit after tax are subtotals. No clerk ever recorded an EBITDA. EBITDA has no document, no voucher and no entry anywhere in the books.

Every income line item and expense line item has a document behind it, and every profit line item is pure arithmetic, so an argument about profit is almost always an argument about a line above it. The distinction matters the moment somebody disputes a figure. The EBITDA line is a sum, so if two people disagree about Anjani Stationers' EBITDA of Rs 53,50,000, there is nothing to examine at that line itself. The disagreement has to be about whether Rs 26,00,000 of other operating expenses belongs there, or whether some of it was really a cost of materials, or whether an item was left out entirely. Arithmetic cannot be wrong in an interesting way. Classification can.

What is gross profit, and what does it isolate?

Gross profit is revenue less what the goods sold actually cost to make or buy. For Anjani Stationers, revenue of Rs 2,70,00,000 less cost of materials consumed of Rs 1,48,50,000 leaves Rs 1,21,50,000, or 45.0 per cent of revenue. Nothing else has been taken off yet. Not the staff, not the electricity, not the van, not the interest, not the tax.

Gross profit isolates the product itself: whether the thing being sold is sold for enough more than it costs to make. A vada pav stall outside a bus depot shows what that means. Gross profit is what is left after the pav, the potatoes, the oil and the gas, and before the rent for the pitch, the helper's wages and the licence fee. Gross profit is the sharpest single question that can be asked of a business. If the answer is bad, nothing further down the ladder can rescue it. A stall selling at a loss on each plate does not fix that by selling more plates. Gross profit is also the rung most sensitive to what a preparer chose to put in the cost of goods line, so it is comparable across two businesses only when the two present that line the same way.

What is EBITDA, and what has deliberately not been taken off?

Take gross profit and remove the costs of running the operation: employee cost of Rs 42,00,000 and other operating expenses of Rs 26,00,000, Rs 68,00,000 together. The remainder is Rs 53,50,000, or 19.8 per cent of revenue, and it carries the name that gets quoted more than any other on the ladder. EBITDAEarnings before interest, tax, depreciation and amortisation. The trading result with all four of those costs still sitting inside it, not yet taken off. spells out its own exclusions: earnings before interest, tax, depreciation and amortisationThe spreading of the cost of something intangible, such as software or a licence, across the years it is expected to be useful, in the way depreciation spreads the cost of a physical asset.. Read as an instruction, the name states exactly what has not happened yet.

EBITDA still has depreciation, interest and tax inside the figure it reports, and the reason it gets quoted so often is precisely the reason it has to be read carefully. The four costs it ignores say most about a business's history and least about its trading this year, so a figure without them still has a use. Depreciation is the cost of equipment bought in earlier years. Interest is the cost of a funding decision. Tax depends on a position that may have nothing to do with this year's trading. With all four stripped out, what remains is the operation as an operation. Seeing the operation on its own is genuinely useful, and the same stripping is why a reader who treats EBITDA as though it were profit is making a serious mistake: a household earning well before counting the loan instalment on the scooter, the fact that the scooter is wearing out, and the tax on the earnings is not a household with money to spare.

What is EBIT, also called operating income, and why is it the fairest comparison rung?

Take EBITDA of Rs 53,50,000 and remove depreciation and amortisation of Rs 12,00,000. The remainder is Rs 41,50,000, or 15.4 per cent of revenue, and it travels under three names that all mean the same figure: EBITEarnings before interest and tax. The result after every cost of operating the business, including depreciation, and before the cost of borrowing and before tax., operating incomeAnother name for the same figure as EBIT: what the operation earned after all its own costs and before financing and tax., and operating profit. Seeing three names for one thing is disorienting the first time, so hold on to the definition rather than the label: everything the operation costs has been taken off, and nothing about how the business is funded or taxed has been.

EBIT sits after every cost of operating and before every cost of financing, so it is the fairest rung on which to compare two businesses. The rung above it is not fair for that job. Two printers with identical trading, one of which bought its machine outright five years ago and one of which bought a newer machine last year, will report similar EBITDA and very different EBIT, and the difference is real: machines wear out, and the newer machine is being consumed faster on paper. Excluding depreciation flatters whichever business has more equipment. EBIT puts that cost back. The rung below it is not fair either. As soon as finance cost comes off, the comparison is between funding decisions rather than operations. One rung, one clean question: how good is this operation at operating? The remaining care needed is that businesses differ in whether they put non-operatingIncome or cost that does not come from the main trade, such as interest earned on a deposit or a gain on selling an old machine. items above or below this line, so check what has been included before comparing two EBIT figures.

What is earnings before tax, and why can it fall when nothing about the trading changed?

EBIT of Rs 41,50,000 less the finance cost of Rs 3,50,000 gives earnings before taxThe profit figure after every cost including interest but before the tax charge for the year. Often shortened to EBT or written as profit before tax. of Rs 38,00,000, or 14.1 per cent of revenue. Earnings before tax is the rung the tax computation starts from, and also the first rung on the ladder that depends on something other than trading.

Earnings before tax is the first rung affected by how the business is funded rather than by how it trades, so two businesses running identically can report very different figures from this point down. Holding everything above EBIT still and changing only the borrowing shows how large that effect gets. Devgiri Notebooks, an invented competitor, has the same revenue of Rs 2,70,00,000, the same gross profit, the same EBITDA, the same EBIT of Rs 41,50,000, and a finance cost of Rs 20,00,000 instead of Rs 3,50,000 because it bought its plant with borrowed money. Its earnings before tax is Rs 21,50,000. Tax at an illustrative 25 per cent takes Rs 5,37,500, leaving profit after tax of Rs 16,12,500. Two businesses, identical operations by construction, and a gap of Rs 13,87,500 in the figure most people quote.

Rung by rung, the two ladders compare like this. At the revenue rung both businesses show Rs 2,70,00,000 and every cost is still inside. At gross profit both show Rs 1,21,50,000 with only materials taken off. At EBITDA both show Rs 53,50,000, with depreciation, interest and tax still inside. At the default EBIT rung both show Rs 41,50,000 at 15.4 per cent of revenue, with everything operational taken off and nothing financial. From the earnings before tax rung down the two split: Rs 38,00,000 against Rs 21,50,000, a gap of Rs 16,50,000, and then Rs 30,00,000 of profit after tax against Rs 16,12,500, a gap of Rs 13,87,500. At the earnings per share rung it is Rs 7.50 against Rs 4.03. Four rungs of perfect agreement, then three of sharp disagreement, and not one rupee of the disagreement is about printing notebooks.

What is profit after tax, and what are the two earnings per share forms?

Earnings before tax less the tax expense of Rs 8,00,000 gives profit after taxThe bottom line of the income statement: what is left for the shareholders once every cost, including interest and tax, has been taken off. of Rs 30,00,000, or 11.1 per cent of revenue, the figure a reader means by the phrase bottom line. Notice that the tax expense is not the Rs 9,50,000 that 25 per cent of Rs 38,00,000 would give. The charge is Rs 8,00,000, an effective rate of 21.1 per cent, and the reasons for the gap are covered under the tax expense line.

Profit after tax belongs to the shareholders, and that raises the question the last rung answers: how much of it belongs to one share? Anjani Stationers has 4,00,000 equity shares of Rs 10 each, in issue for the whole year, so the weighted average number of sharesThe share count averaged over the year, weighted by how long each share was in issue, so shares issued halfway through count for only half the year. is also 4,00,000. Divide Rs 30,00,000 by 4,00,000 and basic earnings per shareProfit for the year attributable to the equity shareholders, divided by the weighted average number of equity shares in issue during that year. is Rs 7.50.

Earnings per share is the only rung that divides the result by the shares it belongs to, so the same profit figure can produce very different per-share figures, and so there is more than one form of it. There are two earnings per share forms and every set of accounts that reports one reports both. Basic uses the shares actually in issue. Diluted assumes everything that could reasonably turn into a share has already done so. Meera Rao, the operations manager at Anjani Stationers, holds options over 25,000 shares that are worth exercising, so the diluted count is 4,25,000 rather than 4,00,000 and the same Rs 30,00,000 is spread over more shares, giving roughly Rs 7.06. Notice which half of the fraction moved: the numerator did not change at all. How the diluted count is arrived at, and which instruments go into it, is a computation covered separately.

Two different earnings per share figures for one business surprise people the first time. Anjani Stationers has a 70 per cent holding in Chitra Binding, and the consolidated statement reports the group. Consolidated profit is Rs 40,00,000. Of that, Rs 37,00,000 is attributable to the shareholders of Anjani Stationers and Rs 3,00,000 to the non-controlling interestThe part of a subsidiary's profit and net assets that belongs to its other shareholders rather than to the parent business., Chitra Binding's founder. Earnings per share uses only the part attributable to the shareholders of the parent, so the numerator becomes Rs 37,00,000 while the denominator stays at 4,00,000 shares, and basic earnings per share is Rs 9.25. Higher numerator, identical share count, higher figure. The share count did not move because acquiring a subsidiary did not issue any new shares in Anjani Stationers.

Which rung does each kind of reader use, and why?

One idea turns the list of definitions into something usable. The rungs are not ranked by quality, with one right answer and five approximations. Each one is the correct figure for a particular reader, and which reader is being served at that moment decides which rung matters.

The rung somebody quotes reveals whose question they are answering, so a figure put in front of a reader is worth identifying by rung before it is judged large or small. EBIT is the profit that exists before the lender has been paid, and therefore the profit available to pay them, so a lender reads EBIT. A share is what an equity analyst is pricing, so the analyst ends up at earnings per share. Profit after tax is the pool a dividend can come out of, so a shareholder reads that rung. The tax authority reads earnings before tax, then applies its own rules to it. Gross profit is the rung an operations manager inside the business can actually move this month, so the manager reads that one.

How does a lender actually write a rung into a loan agreement?

Move out of the classroom for a moment. A rung is not only something people read but something people write into contracts, and the choice of rung decides what the borrower can and cannot do to pass the test. A lender to Anjani Stationers would not write a condition saying profit must stay healthy. The lender would name a rung, name a ratio built on that rung, and name the level. The commonest such test compares EBIT with finance cost: how many times over could the trading have paid the interest?

A test built on the bottom rung can be passed or failed for reasons that have nothing to do with the borrower's trading, so a lender writes EBIT into the agreement rather than profit after tax. Work it on the case. Anjani Stationers has EBIT of Rs 41,50,000 against finance cost of Rs 3,50,000, so the trading covered the interest 11.9 times over. Devgiri Notebooks, with the same EBIT and Rs 20,00,000 of interest, covered it 2.1 times. If the loan agreement carried a covenantA condition written into a loan agreement that the borrower has to keep meeting, such as a minimum ratio, with consequences if it is breached. requiring cover of at least three times, Anjani Stationers passes comfortably and the twin has already breached, and the two businesses print notebooks equally well. Now see why the bottom rung would be a poor test. Profit after tax can rise because a tax item went the borrower's way, and it can fall because the borrower took on more debt, the very thing the lender is trying to watch. Building the test one rung up removes both distortions. The household version is the same shape: a bank assessing a home loan looks at income before the instalment it is about to add, not after.

What does Anjani Stationers' full ladder look like, and where did the year two fall land?

Both years set side by side, one rung at a time, stop the year being a mystery. Revenue rose by 12.5 per cent and profit after tax fell by Rs 8,00,000, a contradiction until the ladder is read rather than only the ends of it.

Read the change column downwards and the year explains itself: gross profit held at exactly 45.0 per cent, EBITDA moved by only Rs 1,00,000, and Rs 7,00,000 of the Rs 8,00,000 fall entered at one rung, depreciation. Locating a fall by rung is the whole purpose of the ladder. The products were sold at the same margin as last year, so nothing went wrong with pricing or with material cost. The extra staff and the higher running costs took almost exactly what the extra gross profit brought in, so the trading operation stood still. Then the useful life of the delivery van was revised during the year, the van is now being written off faster, and depreciation and amortisation rose from Rs 5,00,000 to Rs 12,00,000. Below that, an extra Rs 1,50,000 of finance cost and Rs 1,50,000 less tax expense cancel each other exactly. One rung did almost all of the damage, and a reader who saw only the top line and the bottom line would have gone looking in entirely the wrong place.

Anjani Stationers Private Limited, Chitra Binding Works Private Limited, Devgiri Notebooks Private Limited, Anjani Kulkarni, Meera Rao and the Sunrise Public School group are invented.
Educational material. Not advice on any investment, tax, budget or market position.