Earnings of a Business and How Earnings are Calculated
What are Business Earnings and Why are Earnings Important?
Earnings are important to any business. The basic definition of the term "earnings" is simple, but the concept of earnings has many uses. The earnings of a business are the same as its net income or its profit. Either term means the same thing.
Earnings are usually calculated as all revenues (sales) minus the cost of sales, operating expenses, and taxes, over a given period of time (usually a quarter or a year).
For example, let's say the gross sales of a company are $500,000 for a year. Reduce this number by the cost of sales at $300,000, operating expenses (including depreciation) of $80,000, and taxes of $20,000. The result is the company's earnings (profit, net income) of $100,000.
Why Earnings are Important
Earnings are an important measure for public companies because investors base investment decisions on earnings, and stock price is based on earnings.Stocks Expert Ken Little says that earnings are an important indicator of company health. While earnings reports must be taken in context, earnings per share are the best way to measure the value of a company's stock.
Earnings are important to shareholders because dividends are paid based on annual earnings.
Earnings and Taxes
Earnings are also important to small businesses for tax reasons. The business described above has earnings of $100,000.
The earnings are used to calculate:
- Income taxes. The earnings are included in the individual's personal tax return on Schedule C, for the purpose of calculating individual income taxes. If the business is a corporation, earnings are included on the corporate income tax return, and the corporation's taxes are calculated using this figure.
- Self-employment taxes. For small business owners who must pay self-employment tax (Social security, Medicare tax), the earnings of the business are the basis for this calculation.
Earnings in Investment and Stock Price
Earnings are expressed in different ways for purposes of investing. Here are some common investment terms associated with the term "earnings."
Earnings per share (EPS) (net profit divided by the number of shares) is used for publicly held companies who have actively traded stock. The earnings per share figure is probably the most used financial calculation. IEPS one way to analyze the company's value. Earnings per share is calculated as:
Total net income available to common shareholders (shareholders of common stock) divided by the number of common shareholders.
EBITDA stands for "Earnings before interest and taxes, depreciation and amortization." This earnings calculation includes only sales minus cost of goods sold and general and administrative expenses. EBITDA is a description of the profit the company would have had if it didn't have to pay interest expenses on business debts and any taxes, and before any calculations for depreciation and amortization.
Joshua Kennon, Investing for Beginners Expert, says EBITDA is "intended to be an indicator of a company's financial performance."