Gross and operating profit

0:00Voiceover: What I want to do in this video is to see if we can understand all of the different parts of kind of a traditional income statement. As we get into more and more complicated examples, you'll see more and more complicated income statements, but this is a good start.

0:13What I've done here is I've drawn the income statements for actually two businesses. One is Ben's Shoes, and one is Jason's Shoes. I did that because these are fundamentally the same business, but they have a slightly different capital structure, and we'll talk about what that means in a second, but they're both shoe stores.

0:29They literally, they buy shoes from shoe manufacturers. They put them on their shelves, and then customers come in and buy those shoes. The first line, we're pretty familiar with it already. This is the revenue, this is the sales for each of these shoe stores.

0:43In the case of a shoe store, it's literally just going to be a measure of the cash that the customers are paying for the shoes. You wouldn't have something like accounts receivables, where people can pay months later. Most of it will just be cash. Cost of goods sold, in this example, we're just going to assume it to be the actual cost of a shoe.

1:02If I sold a pair of $100 shoes, but I had to pay $50 to the shoe manufacturer for those shoes, that $50 would be the cost of goods sold. So this $100,000 is actually the cost of the $200,000 in sales. Then when you just take the cost of goods sold from that revenue, you get something called gross profit, and really, the focus of this is is, of this video is to try to understand the difference between gross profit, operating profit, pre-tax income, net income.

1:33Gross profit is the first time that you kind of think of profit, and the reason why it's called "gross" is because we've just thought about the profit from selling that incremental shoe, and sometimes some other costs are thrown in there. Sometimes advertising, sometimes some other cost associated with the store, but for this example, it's just the profit straight from selling that incremental shoe, and that's why we call it gross, since we haven't taken out other things yet.

1:59Then, below that line, we have all of the other expenses, the expenses associated with running the store. The kind of the overhead of running that store, So we have the rent, you have the salaries, you have the depreciation and amortization. Maybe you're depreciating the cost of your cash register and the shelves, and whatever else, and then you can have other things like utilities, and you can see both Ben's Shoes and Jason's Shoes are completely identical up to this point.

2:22They have the same revenue, gross profit, even the same expenses. And so when you take all of these expenses out from the gross profits, you take 100,000 minus all of these, and I've written all of the stuff you subtract with parentheses around them, so that these are expenses, these are negatives.

2:37You get the operating profit, and you see that both of these are the same number. What operating profit tells you is how much profit is coming from the business. It's before we think about how the business is structured. It doesn't think about things like interest income from your bank account, or interest expense on any loans you have.

2:57It's from the business itself, operating profit, and since these are identical businesses, they have the same exact operating profit. Where they start to diverge is below that line. Above this line right over here is the income statement, down here is the balance sheet.

3:13Their balance sheets are identical, except for Jason's Shoes has $100,000 in debt, and Ben's Shoes has no debt. Ben has no interest expense, while Jason does have a $10,000 interest expense, so it's about 10% per year. That's why these two income statements start to diverge, but notice, we didn't put this expense up there because it has nothing to do with the operations.

3:35It's dependent on how the operations were financed. Once you subtract that out, then you actually have your pre-tax income, and if we assume that we have to pay taxes, this is how much we pay in taxes, and this is actually the net income that goes to the owners of the company.