Interest and profit are both results of the way in which organizations make money, but make no mistake: they are not the same. The challenge is that you cannot directly compare interest and profit because they’re separate ideas. By way of metaphor, it would be like comparing a window and a garage door; interest is an activity typically related to banks (or other loaning institutions), whereas profit is common to all organizations.
In short, interest is income that lenders (usually banks) make on loans, whereas profit is the net result of a company’s income (after all charges are accounted for) — whether that company is a bank or not.
The difference hinges on two questions:
First, we have to define the company’s core activity: what product or service does it provide to make money? If the answer is “loans,” it’s a bank or other loaning institution, whose income comes from interest.
Second, we need to ask if the income for the organization (bank or other) is net of charges: have we subtracted costs from the money coming into the company? If the answer is yes, then the sum is profit and not revenue. This is true whether we’re talking about a bank or another company.
Again, the simplest way to differentiate interest and profit is to recognize that they are separate ideas: interest is a type of income common to banks, whereas profit is equal to income minus costs and expenses — whether it’s a bank or another company.
Interest as Income (not profit) for Banks and Other Loaning Institutions
The word “interest” carries a negative connotation for many people, but it’s an important form of income for banks. As consumers, our first interaction with the interest is often in the context of a student or car loan, or a mortgage. We borrow money from the bank, and we pay them interest on this money — often at fixed or variable rates over time. What many people fail to recognize is that a bank is a business… and a good one at that.
Interest is the revenue a bank makes, and loans are its core business. But small loans to consumers (people like you and me) are just a small portion of a bank’s lending activity. They also provide credit facilities to consumers and companies, huge long-term loans to companies, and short-term loans to companies for cash management.
This does not, however, mean that interest is the same as profit for a bank. Interest is incoming money, which means it’s revenue. The bank has costs and expenses of its own, such as employee salaries, travel expenses, rent, and office supplies, among others. When we subtract these charges from the interest income, the result is profit.
Interestingly enough, one of the costs a bank has to pay can actually be an interest payment! This is because banks sometimes need to borrow money from other banks in order to fund their operations.
This is where capitalism gets funny — and it can get very complex, very quickly. Imagine the following:
- Bank A loans money to Company A, and
- Bank B loans money to Bank A and Company B, then
- Bank C loans money to Bank A, Bank B, Company A, and Company B.
All of these loans require interest payments. All of those interest payments are costs for a bank, and revenue for another bank. It’s a circle of interest and debt.
It’s important to note, however, that banks are not the only institutions that make money by lending money. Other examples include insurance firms, pawn shops, cashier’s check issuers, check cashing locations, payday lending, currency exchanges, and micro-loan organizations.
However, these entities often don’t have the creditworthiness of a normal bank, which means
Interest in Normal Companies
While lending is not the core business of a “normal” company, it can be a secondary activity. Many large corporations have a surplus of cash that they don’t use in their core activities.
What can they do with this money? Instead of letting it sit idle in a bank account, they can lend it to employees and other companies, or they can buy bonds from governments and other institutions. In this way, they become a lender. And they make money from that loan.
However, we typically do not think about interest income for companies as revenue. Instead, it’s considered an “other income,” which is reflected low on the profit & loss statement. While interest income on a bank’s Profit & Loss statement will appear as revenue, interest income on a company’s P&L shows up as “interest income,” which is located after operating profit and just before interest expense. The designation “revenue” is reserved for money earned through the company’s core operations.
Here’s an example P&L of a bank vs a normal company, both of which have earned interest of $100,000:
Profit in Banks vs Profit in All Other Companies
A bank’s profit is equal to its interest income minus any interest it pays on loans or customer deposits and operating expenses, and minus taxes.
A company’s profit is equal to revenue and interest income (if present), minus CoS, operational costs, interest expense, and taxes due.
The difficult part of profit calculation for a bank is understanding how its cost of goods sold (a.k.a. cost of sales) works. If you’re unfamiliar with cost of goods sold, you can think of it as the direct cost to produce the product or service. For a baker, it’s the cost of dough, for example.
A bank, however, lends money. So what is the “cost to produce” this money? In short, Cost of Sales for a bank is the sum of interest paid on customer deposits and on loans from other banks. (Note: the difference between interest earned and interest paid is referred to as funds transfer pricing, but you don’t need to understand it in depth to comprehend interest.)
Are you starting to see the dynamic here? Banks borrow and lend money to the same people to make money. One big circle.
To summarize, profit in a bank is equal to its income from lending minus its cost of borrowing minus operational expenses. Meanwhile, a company’s profit is equal to its income from proving a service or product minus operational expenses, plus income from loans, minus interest. Pretty cool, huh?
Profits Interest: Don’t Get Confused
While the term Profts Interest includes both of our keywords, it has nothing to do with either one of them! Profits interest is a form of compensation for employees or partners of a firm in which the latter two are “paid” in equity the firm generates after the contract is signed.
For example, imagine you work for a wholesale watch company, and you want to get a share in the company but don’t have the personal capital to buy in. In this case, you could negotiate a profits interest arrangement with the company.
Today, the company is worth $500. You buy a 10% profits interest share. A year from now, the company is worth $600. You own 10% of this increase, or 10k ($600-$500=$100, and $100*10%=$10). Overall, this means you own about 1.7% of the company (10/600).
The reason this is called “interest profit” has to do with the futuristic nature of the employee’s or partner’s earnings. In some way it’s a manipulation of the traditional meaning of the words. “Interest” in this context simply means “earning after the initial engagement,” and “profit” means “earnings.”
Obviously, the core difference between profits interest and the traditional use of the each term is that the former concerns an individual, while the latter concerns a bank or company.
In other words, you can think of the difference as a a function of entity: whether the entity is a bank or company, or an individual’s participation in a company.
Conclusion
Taken from a “top down” perspective, we can think about interest and profit as the function across companies. All company’s make profit, but only some generate income from interest. In most cases, companies that generate income from are banks or other lending institutions. However, normal companies can get income from loans, it’s just not considered their “revenue” on the profit and loss statement.
Income and profit should not be confused with “profits interest,” which an entirely unrelated concept that deals with compensation companies provide to partners or employees based on value of the company generated in the future.
