Subtle Differences in Key Financial Metrics

This article looks to highlight some subtle differences in seemingly identical accounting metrics.

Do you ever feel like Financial Statements are a labyrinth, designed to confuse even the bravest CEOs? You’re not alone.

Thousands of years ago the oldest known written language, Sumerian cuneiform, was developed primarily for accounting purposes. Fast forward to today, and the complexity has increased, but the importance remains (well maybe not quite as important as the oldest known written language ever discovered).

EBITDA, Operating Profit, Net Profit – they could sound like characters of a computer game, not metrics that hold the key to your business’s success. But fear not intrepid explorer, today we’re grabbing a metaphorical ball of financial twine and venturing into the money maze, ready to unravel the mysteries of these seemingly identical terms. 

The Profit Powerhouse 

Let’s look at some other Profitable comparatives.

Most businesses will implement the big three profitability metrics for Board reporting, being: Gross Profit, Operating Profit, and Net Profit.  

Imagine them as leads in a Sales Funnel; each stage representing a more refined measure of your company’s success, with an ability to spot where your Business Model gets a bit leaky. 

• What is Gross Profit: following on from Revenue, this is the party at the starting line. It reveals how much revenue you have left, after subtracting any costs directly associated in producing your goods or services (think raw materials, labor, delivery). If you’re negative at this stage then you either need to put your selling prices up, re-negotiate your buying costs, or very quickly re-evaluate the viability of your business. The only time you may be prepared to make a loss at this stage is if you are selling a Service or Product as a loss-leader to earning profitable Revenue elsewhere. In theory … it shouldn’t matter whether you sell one of something or a thousand, the Profitability Margin (%) should remain the same-ish.

• What is Operating Profit: Now things get interesting.  This financial metric takes Gross Profit and subtracts all of the expenses that keep your business running – salaries, marketing costs, rent et cetera. That’s likely your big three costs. You should technically include Depreciation and Amortisation here too, but see EBITDA vs Operating Profit, below. If you’re making a loss at this stage then it may simply be a case of needing to sell more items to cover those (nearer) fixed costs. Most of these costs can be controlled relatively quickly when required.

• What is Net Profit: Ah, the holy grail! This is your ultimate destination in the profit funnel. It’s what’s left over after ALL expenses are paid – including interest and taxes. If you’re making a profit here, then well done. 

EBITDA vs. Operating Profit: Unmasking the Profitability Twins 

EBITDA and operating profit are both crucial measures of a company’s operational profitability, but they can serve different purposes and could be calculated very differently. 

• EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation): This metric strips out the effects of financing and accounting policy decisions making.

By excluding interest (on loans), taxes paid or deferred, depreciation, and amortisation, your EBITDA provides a clearer picture of a company’s operational performance. It’s particularly useful for comparing companies across different industries as it removes factors that can vary widely between company’s, especially of different sizes and ownership structures.

SaaS investors will always talk EBITDA and I would advise any SaaS company to shuffle their accounts to begin reporting in this format.

• Operating Profit: In practice, this accounting metric should include all of the turnover and costs within EBITDA but the subtle difference is that it includes Depreciation and Amortisation too. This provides insight into the efficiency of a company’s operations including where one may purchase their Fixed Assets opposed to Leasing.

Do also note that your Statutory Year End accounts will report in regards to Operating Profit as opposed to the more internal reporting EBITDA formula.

ROCE vs. ROA: The Battle of the Returns 

Now, let’s delve deeper into efficiency. Here, our contenders are Return on Capital Employed (ROCE) and Return on Assets (ROA). Both measure how effectively you’re using your resources to generate profit, but they approach it from slightly different angles. Which formula to choose will likely depend on the industry you operate within. 

• Return on Capital Employed (ROCE): This metric focuses on the capital you’ve invested in your business, including both equity (which includes Retained Earnings by the way) and debt (which means the loans you have received to run it). It essentially asks, “For every pound I’ve continued to invest, how much profit am I generating each year?”. Think of it as the efficiency rating for your entire business ecosystem.

• Return on Assets (ROA): The subtle difference with this metric is that it takes a broader view, looking at how much profit you’re generating from ALL your assets, regardless of whether they were funded through equity or debt. This metric is likely more useful for smaller businesses who do not have much Debt / Loan funding.

The good news is, in my experience, if an investor wants you to report on either ROCE or ROA’s, they will tell you which one they want to see.  

The Asset Arena – Fixed vs. Current 

Next, let’s address the asset showdown: Fixed Assets vs. Current Assets. These terms categorise the resources your business owns, but their timeframes differ greatly.

• Fixed Assets: These are your long-term investments – think buildings, machinery, equipment. They’re like the sturdy pillars of your business, providing the foundation for you to operate but not readily convertible to cash. 

• Current Assets:  These are your business’s short-term resources – think inventory, cash, accounts receivable (money owed to you by customers). They’re the lifeblood of your day-to-day operations, and in theory readily convertible to cash to keep the business running smoothly. 

Total Assets vs. Current Assets: The Big Picture vs. The Liquidity Lens 

Before we reach the exit of the money maze, we face a two-door dilemma: Total Assets or Current Assets? Both sound promising, but only one leads you closer to the golden exit (financial success). 

• Total Assets: Think of this as the grand treasure chest at the centre of the maze. It represents EVERYTHING your company owns, both the long-term booty you’ve accumulated over time and the loot you plan to keep for future adventures. Think of it as the combined value of your majestic ship (fixed assets like property and equipment), the cannons and stashed gold (current assets like inventory and cash), and even the cryptic treasure maps (intangible assets like intellectual property). It’s the ultimate brag about your overall wealth and resource base. 

• Current Assets:  These are your trusty coin purse, the readily spendable gold you need to navigate the maze’s immediate challenges. These assets are expected to be converted to cash within a year – think of it as the inventory you can quickly sell, the accounts receivable (money owed to you by customers) you’ll collect soon, and of course, the actual cash you have on hand. These are your financial lifeblood, ensuring you have enough coins to pay the maze’s trolls (expenses) and keep moving forward. 

Knowledge is Power – Escape the Maze! 

The maze of financial jargon might seem daunting, but with a little exploration, you can become a master navigator. By understanding the subtle differences between these key metrics, you can make informed decisions, identify areas for improvement, and ultimately, unlock the true potential of your business.  So, ditch the confused frowns and step into the money maze with confidence. Remember, knowledge is the ultimate weapon in the battle for financial success!

This post was written by Christopher Grubb. You can find out more about me here.

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I hope the above has helped.

The role of the Finance Director does not need to be a full-time overhead for someone to be committed and make a difference to your business. My aim is to simplify the financial performance, planning and strategic positioning for SaaS and Tech businesses who just want their world to be uncomplicated and thrive.

Please feel free to message me with any comments or questions. Or find me on LinkedIn here.