Gross and operating profit | Stocks and bonds | Finance & Capital Markets | Khan Academy

Summary

This video explains the key components of an income statement using the example of two shoe stores, Ben's Shoes and Jason's Shoes. Both businesses have the same operations but differ in their capital structure. The video breaks down revenue, cost of goods sold, and gross profit, before discussing operating profit, which excludes financial factors like interest expenses. It highlights the difference in their income statements due to Jason’s debt and interest expense, ultimately leading to variations in pre-tax income and net income. The focus is on understanding how profit is generated at each stage of the income statement.

Takeaways

• 😀 The video explains the key components of an income statement, using two businesses as examples: Ben's Shoes and Jason's Shoes.
• 😀 Both businesses are fundamentally the same, selling shoes, but differ in their capital structure.
• 😀 Revenue refers to the total sales from customers, typically paid in cash without accounts receivable for shoe stores.
• 😀 Cost of Goods Sold (COGS) represents the cost of purchasing shoes from manufacturers, and is subtracted from revenue to determine gross profit.
• 😀 Gross profit is the initial profit from selling shoes, calculated as revenue minus COGS, before considering other operating expenses.
• 😀 Operating expenses, such as rent, salaries, and utilities, are deducted from gross profit to calculate operating profit.
• 😀 Operating profit reflects how much profit the business makes from its core operations, excluding interest and tax considerations.
• 😀 The operating profits of Ben's Shoes and Jason's Shoes are identical up to this point, as they have the same revenue and expenses.
• 😀 The key difference between the two businesses arises from Jason's Shoes having $100,000 in debt, while Ben's Shoes has no debt.
• 😀 Jason's Shoes incurs a $10,000 interest expense due to its debt, which is subtracted after operating profit to determine pre-tax income.
• 😀 After accounting for interest expense and taxes, the net income represents the final profit available to the owners of the business.

Q & A

What is the purpose of the video?

The purpose of the video is to explain the different parts of a traditional income statement, particularly focusing on how gross profit, operating profit, pre-tax income, and net income differ and what each represents in a business.

Why are Ben's Shoes and Jason's Shoes used for comparison?

Ben's Shoes and Jason's Shoes are used for comparison because they are fundamentally the same business model—both sell shoes—but they differ in their capital structure. This allows for a discussion of how financing affects financial results.

What does the 'gross profit' represent?

Gross profit represents the profit made from selling a product after subtracting the cost of goods sold, but before accounting for other operating expenses such as rent, salaries, and utilities.

What is meant by 'cost of goods sold' in this context?

Cost of goods sold refers to the actual cost incurred by the store to purchase the shoes from manufacturers. For example, if a shoe is sold for $100 and costs $50 from the manufacturer, the cost of goods sold is $50.

How is operating profit different from gross profit?

Operating profit is calculated by subtracting all operating expenses (like rent, salaries, and depreciation) from gross profit. It reflects the profit from the core operations of the business, excluding financing-related costs like interest.

What does operating profit tell us about a business?

Operating profit tells us how much profit the business is making from its core activities, before considering the impact of how the business is financed (e.g., loans or interest income/expenses).

Why do Ben's Shoes and Jason's Shoes have the same operating profit?

Ben's Shoes and Jason's Shoes have the same operating profit because their revenue and operating expenses are identical. The difference in their financials arises only from their financing structure (i.e., debt).

What impact does debt have on Jason's Shoes' income statement?

The debt affects Jason's Shoes' income statement by adding an interest expense of $10,000, which reduces its pre-tax income compared to Ben's Shoes, which has no debt and therefore no interest expense.

What is the significance of pre-tax income?

Pre-tax income represents the profit a business makes before taxes are subtracted. It accounts for all income and expenses, including interest expenses or income, but does not yet factor in tax obligations.

What does net income represent on the income statement?

Net income is the final profit a company makes after accounting for all expenses, including operating costs, interest expenses, and taxes. It is the amount that remains for the owners of the business.