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Equity profit is the money a company earns from using external capital in its business operations. The most frequent measurement for this profit is the return on equity ratio. Owners and managers may calculate this ratio using a simple mathematical formula. One common formula is to divide the net profit of a project by the average equity outstanding. For example, net profit (income less expenses) of $10,000 US Dollars (USD) divided by the average outstanding equity of $25,000 USD is 40 percent. Therefore, $.40 USD of every $1 USD in profit comes from equity, i.e. equity profit.
Tracking the profit from equity is quite common, as it allows a company to determine the effectiveness of outside funding used within the business. This ratio is primarily a management accounting tool, as opposed to financial accounting tools. The equity profit of various projects allows companies to make decisions on which projects will bring the most money back into the firm. Because companies typically have a limited source of capital, they will typically make choices to spend capital on the projects with the most profit potential.
Financial accounting measures the amount of overall income and/or profit a company generates from its business operations. While this figure is important, it is also necessary to breakdown the company into smaller parts in order to determine profitability and efficiency of operations. Not only does equity profit help accomplish this goal, but it also provides a metric for historical purposes. This allows the company to make intelligent decisions based on previously successful business operations.
Gross and net profit calculations are financial accounting figures closely related to the equity profit calculation. Gross profit represents total sales revenue less the cost of goods sold to generate that revenue. Net profit is sales revenue less the cost of goods and expenses needed to generate the sales. This information provides a profit record for a specific period of time. Outside stakeholders are also interested in these figures, as they represent the profitability of the company as a whole.
Where both gross and net profit ratios are pure accounting figures, equity profit represents the actual cash generated from a business activity. This capital represents the economic wealth increases (or value added) to a company’s current assets. The company will report these increases on its balance sheet, which presents a snapshot in time of the company’s total value. Economic wealth is often seen as more important because it represents tangible items the company is left with if it shuts down operations.