Understanding Business Accounting For Dummies, 2nd Edition (67 page)

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A business can downsize its assets and therefore reduce its fixed expenses to fit a lower sales level, but that can be a drastic reaction to what may be a temporary downturn. After deducting cost of goods sold, variable operating expenses, and fixed operating expenses, the next line in the management profit and loss account is operating profit, which is also called
earnings before interest and tax
(or
EBIT
). This profit line in the report is a critical juncture that managers need to fully appreciate.

From operating profit (EBIT) to the bottom line

After deducting all operating expenses from sales revenue, you get to earnings before interest and tax (EBIT), which is £3,550,000 in the example.
Operating
is an umbrella term that includes cost of goods sold expense and all other expenses of making sales and operating your business - but not interest and tax. Sometimes EBIT is called
operating profit
, or
operating earnings
, to emphasise that profit comes from making sales and controlling operating expenses. This business earned £3,550,000 operating profit from its £52 million sales revenue - which seems satisfactory. But is its £3,550,000 EBIT really good enough? What's the reference for answering this question?

The main benchmark for judging EBIT is whether this amount of profit is adequate to cover the
cost of capital
of the business. Chapter 6 explains the various assets that a business needs to make sales and earn profit. A business must secure money to invest in its various assets - and this capital has a cost. A business has to pay interest on its debt capital, and it should earn enough after-tax net income (bottom-line profit) to satisfy its owners who have put their capital in the business. See the sidebar ‘How much net income is needed to make owners happy?' in this chapter.

Nobody - not even the most die-hard humanitarian - is in business to make a zero EBIT. You simply can't do this, because profit is an absolutely necessary part of doing business - and recouping the cost of capital is why profit is needed.

How much net income is needed to make owners happy?

People who invest in a business usually aren't philanthropists who don't want to make any money on the deal. No, these investors want a business to protect their capital investment, earn a good bottom-line profit for them, and enhance the value of their investment over time. They understand that a business may not earn a profit but suffer a loss - that's the risk they take as owners.
As described in Chapters 6 and 11, how much of a business's net income (bottom-line profit) is distributed to the owners depends on the business and the arrangement that it made with the owners. But regardless of how much money the owners actually receive, they still have certain expectations of how well the business will do - that is, what the business's earnings before interest and tax will be. After all, they've staked their money on the business's success.
One test of whether the owners will be satisfied with the net income (after interest and tax) is to compute the
return on equity
(ROE), which is the ratio of net income to total owners' equity (net income ÷ owners' equity). In this chapter's business example, the bottom-line profit is £1.9 million. Suppose that the total owners' equity in the business is £15.9 million (as shown in Figure 8-1 for the business example). Thus, the ROE is 12 per cent (£1.9 million ÷ £15.9 million). Is 12 per cent a good ROE? Well, that depends on how much the owners could earn from an alternative investment. We'd say that a 12 per cent ROE isn't bad. By the way, ROE is also known as ROSI:
return on shareholders' investment
.
Note:
ROE does not imply that all the net income was distributed in cash to the owners. Usually, a business needs to retain a good part of its bottom-line net income to provide capital for growing the business. Suppose, in this example, that none of the net income is distributed in cash to its owners. The ROE is still 12 per cent; ROE does not depend on how much, if any, of the net income is distributed to the owners. (Of course, the owners may prefer that a good part of the net income be distributed to them.

Don't treat the word
profit
as something that's whispered in the hallways. Profit builds owners' value and provides the basic stability for a business. Earning a satisfactory EBIT is the cornerstone of business. Without earning an adequate operating profit, a business could not attract capital, and you can't have a business without capital.

Travelling Two Trails to Profit

How is the additional information in the management profit and loss account useful? Well, with this information you can figure out how the business earned its profit for the year. We're not referring to how the company decided which products to sell, and the best ways to market and advertise its products, and how to set sales prices, and how to design an efficient and smooth running organisation, and how to motivate its employees, and all the other things every business has to do to achieve its financial goals. We're talking about an
accounting explanation of profit
that focuses on methods for calculating profit - going from the basic input factors of sales price, sales volume, and costs to arrive at the amount of profit that results from the interaction of the factors. Business managers should be familiar with these accounting calculations. They are responsible for each factor and for profit, of course. With this in mind, therefore: How did the business earn its profit for the year?

First path to profit: Contribution margin minus fixed expenses

We can't read your mind. But, if we had to hazard a guess regarding how you would go about answering the profit question, we'd bet that, after you had the chance to study Figure 9-2, you would do something like the following, which is correct as a matter of fact:

Computing Profit Before Tax