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expenses in future years. The thinking is that taking a big bath allows a business to start over by putting bad news behind it, wiping the slate clean so that future years escape these charges.
PROFIT RATIOS
Owners take the risk of whether their business can earn a profit and sustain its profit performance over the years. How much would you be willing to pay for a business that reports a loss year after year? The value of the owners’ investment depends first and foremost on the profit performance of the business. Making sales and controlling expenses is how a business makes profit, of course. The profit residual from sales revenue is measured by a return-on-sales ratio, which equals a particular measure of profit divided by sales revenue for the period. An income statement reports several profit lines, beginning with gross margin down to bottom-line net income.
47
F I N A N C I A L R E P O R T I N G
Figure 4.5 shows four profit ratios for the business example; each ratio equals the profit on that line divided by sales revenue. These return-on-sales profit ratios are not required to be disclosed in the income statement. Generally speaking, businesses do not report profit ratios with their external income statements, although many companies comment on one or more of their profit ratios elsewhere in their financial reports. Managers should pay very close attention to the profit ratios of their business of course.
The company’s net income return on sales ratio is 4.0 percent ($1,585,587 net income ÷ $39,661,250 sales revenue =
4.0%). From each $100.00 of its sales revenue, the business earned $4.00 net income and had expenses of $96.00. The net income profit ratio varies quite markedly from one industry to another. Some businesses do well with only a 1 or 2
percent return on sales; others need more than 10 percent to justify the large amount of capital invested in their assets.
A popular misconception of many people is that most businesses rip off the public because they keep 20, 30, or more percent of their sales revenue as bottom-line profit. In fact, very few businesses earn more than a 10 percent bottom-line profit on sales. If you don’t believe me, scan a sample of 50 or 100 earnings reports in the Wall Street Journal or the New York Times. The 4.0 percent net income profit ratio in the Profit
Income Statement
Ratios
Sales revenue
$39,661,250
Cost-of-goods-sold expense
$24,960,750
Gross margin
$14,700,500
37.1%
Selling and administrative expenses
$11,466,135
Earnings before interest and income tax
$ 3,234,365
8.2%
Interest expense
$
795,000
Earnings before income tax
$ 2,439,365
6.2%
Income tax expense
$
853,778
Net income
$ 1,585,587
4.0%
FIGURE 4.5 Return-on-sales profit ratios.
48
I N T E R P R E T I N G F I N A N C I A L S T A T E M E N T S
example is not untypical, although 4.0 percent is a little low compared with most businesses.
Serious investors watch all the profit ratios shown in Figure 4.5. The first ratio—the gross margin return-on-sales ratio—is the starting point for the other profit ratios. Gross margin (also called gross profit ) equals sales revenue minus only cost-of-goods-sold expense. The company’s gross margin equals 37.1 percent of sales revenue (see Figure 4.5). If its gross margin ratio is too low, a business typically cannot compensate for this serious deficiency in gross margin by cutting other operating expenses, so its bottom line suffers. An inadequate gross margin cascades down to the bottom line, in other words. Therefore investors keep a close watch for any slippage in a company’s gross margin profit ratio. Investors and stock analysts keep a close eye on year-to-year trends in profit ratios to test whether a business is able to maintain its profit margins over time. Slippage in profit ratios is viewed with some alarm. A business’s profit ratios are compared with its main competitors’ profit ratios as a way to test of the comparative
PROFIT RATIOS
Owners take the risk of whether their business can earn a profit and sustain its profit performance over the years. How much would you be willing to pay for a business that reports a loss year after year? The value of the owners’ investment depends first and foremost on the profit performance of the business. Making sales and controlling expenses is how a business makes profit, of course. The profit residual from sales revenue is measured by a return-on-sales ratio, which equals a particular measure of profit divided by sales revenue for the period. An income statement reports several profit lines, beginning with gross margin down to bottom-line net income.
47
F I N A N C I A L R E P O R T I N G
Figure 4.5 shows four profit ratios for the business example; each ratio equals the profit on that line divided by sales revenue. These return-on-sales profit ratios are not required to be disclosed in the income statement. Generally speaking, businesses do not report profit ratios with their external income statements, although many companies comment on one or more of their profit ratios elsewhere in their financial reports. Managers should pay very close attention to the profit ratios of their business of course.
The company’s net income return on sales ratio is 4.0 percent ($1,585,587 net income ÷ $39,661,250 sales revenue =
4.0%). From each $100.00 of its sales revenue, the business earned $4.00 net income and had expenses of $96.00. The net income profit ratio varies quite markedly from one industry to another. Some businesses do well with only a 1 or 2
percent return on sales; others need more than 10 percent to justify the large amount of capital invested in their assets.
A popular misconception of many people is that most businesses rip off the public because they keep 20, 30, or more percent of their sales revenue as bottom-line profit. In fact, very few businesses earn more than a 10 percent bottom-line profit on sales. If you don’t believe me, scan a sample of 50 or 100 earnings reports in the Wall Street Journal or the New York Times. The 4.0 percent net income profit ratio in the Profit
Income Statement
Ratios
Sales revenue
$39,661,250
Cost-of-goods-sold expense
$24,960,750
Gross margin
$14,700,500
37.1%
Selling and administrative expenses
$11,466,135
Earnings before interest and income tax
$ 3,234,365
8.2%
Interest expense
$
795,000
Earnings before income tax
$ 2,439,365
6.2%
Income tax expense
$
853,778
Net income
$ 1,585,587
4.0%
FIGURE 4.5 Return-on-sales profit ratios.
48
I N T E R P R E T I N G F I N A N C I A L S T A T E M E N T S
example is not untypical, although 4.0 percent is a little low compared with most businesses.
Serious investors watch all the profit ratios shown in Figure 4.5. The first ratio—the gross margin return-on-sales ratio—is the starting point for the other profit ratios. Gross margin (also called gross profit ) equals sales revenue minus only cost-of-goods-sold expense. The company’s gross margin equals 37.1 percent of sales revenue (see Figure 4.5). If its gross margin ratio is too low, a business typically cannot compensate for this serious deficiency in gross margin by cutting other operating expenses, so its bottom line suffers. An inadequate gross margin cascades down to the bottom line, in other words. Therefore investors keep a close watch for any slippage in a company’s gross margin profit ratio. Investors and stock analysts keep a close eye on year-to-year trends in profit ratios to test whether a business is able to maintain its profit margins over time. Slippage in profit ratios is viewed with some alarm. A business’s profit ratios are compared with its main competitors’ profit ratios as a way to test of the comparative
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