Using gross profit margin to analyze profitability

Gross profit margin measures the proportion of profit yielded by sales. To calculate this ratio, divide gross profit by sales revenue:

Gross profit margin = Gross profitSales revenue

It is also knows as gross profit ratio or percentage.

Calculating gross profit margin

For the year ended April 2, 2016, Michael Kors Holdings Ltd. had gross profit of $2,797.2 million and revenue of $4,712.10. The company’s gross profit margin for that year was equal to 2,797.2/4,712.10 or 59.4%.

Analysis

Michael Kors’ gross profit margin of 59.4% compares unfavorably with last year, 60.6%. However, it is higher than Ralph Lauren Corp.’s gross profit ratio of 56.5% for the year ended April 2, 2016, indicating that Michael Kors yields more profit from its sales than Ralph Lauren. Michael Kors either charges a higher markup on its products or makes them more cheaply than Ralph Lauren.

To better understand the meaning of a company’s gross profit margin, compare this ratio with prior years, looking for regular increases each year. Healthy companies can charge their customers a robust markup. Also compare your company with competitors. In general, competing companies’ gross profit ratios should be similar.

Profitability versus volume

Companies usually adopt different strategies to manage a trade-off between profitability and volume. Usually companies with valuable brand names (such as Ralph Lauren and Michael Kors) have the ability to charge high prices and limit volume. Companies that sell commodity types of goods (such as groceries) have little choice but to charge low, competitive prices and push up the volume. Consider the difference between an upscale department store, such as Nordstrom (36.5%) and a high volume discount store, such as Wal-Mart (25.1%).

Gross profit margin versus net profit margin

Gross profit margin is not the only ratio that analysts use to measure profitability. Analysts also use net profit margin, computed as net income divided by sales revenue. Gross profit margin focuses exclusively on one expense, cost of goods sold. However, net profit margin accounts for all of the expenses of a company, including selling, general, and administrative expenses and even income taxes. When setting prices, think about this trade-off between high prices and volume, and try to select a happy medium that will maximize your total profits.

 

Using Evernote for your to-do list

I’m a big fan of the note-writing and sharing app, Evernote. As a professor, a University administrator, a husband, and a father, I am constantly receiving tasks and little pieces of information that I’m expected to keep track of and complete, sooner or later.  Evernote allows me to keep a collection of to-do lists for all of my projects at work, home, and play. I can access it on all of my devices.

evernote

How I record tasks

Whenever I accept to do tasks, I create a new note. The heading in the note describes the task, usually with a verb (i.e. “Prepare November 10 class”). Within the note, I sometimes write more details about the task that I need to remember. I sometimes create checklists within notes. And I keep track of the progress of each tasks within these notes. Using my smartphone, I can take a picture of something, and then turn that into a note. Or I can forward an e-mail message to create a note.

I have created one notebook for each project or category of work I do. For example, each class I teach has a notebook. I keep a “blog” notebook for this blog. I have a “money” notebook for my personal finances. I assign every note (or task) to one of these notebooks.

Whenever a task carries a due date, I record it as a “reminder” part of the note.

I also assign “tags” to notes. I have created a separate tag for each person I work with, so that I can look up every note that is associated with each person.

A daily agenda

I can look at lists of due dates within individual notebooks, or for all notes at once in order to identify that tasks that must be completed soon. Then I mark each task I plan to do now with a “shortcut,” indicated with a five-point star. Then I search through different notebooks, assigning shortcuts to whatever tasks I plan to do next. As such, the list of shortcuts is my short “to do” list.

Alternatively, I sometimes work on one project at a time. When doing this, I focus on just one notebook, scrolling through the tasks as I prioritize and work through them.

Meetings

When I meet with individuals to go over current projects, I look up all notes associated with their tags. This allows me to follow up on all of the notes associated with each person.

Completing tasks

When I complete a task, I delete it. Evernote saves all deleted tasks within its “trash” notebook.

Multiple devices

Evernote features apps for iOS, Android, Windows and Mac OS, synchronizing tasks across all devices. This allows me to access my lists wherever I am.

Annoying things about Evernote

Evernote was not really designed to handle to-do lists. It takes a few steps to access a list of tasks sorted by their due dates. Notebooks will sort tasks alphabetically or according to their creation dates, but not according to their due dates.

I wish Evernote would allow me to assign tasks to specific time periods. I wish that I could take a note (say, “Prepare November 10 class”), and assign it to a specific time and date (say, for one hour on November 9). Some third-party apps that will handle this, but I’ve avoided them for security reasons.

 

What are current assets?

Current assets are assets deemed to be liquid enough to be converted to cash within one year or less. The balance sheet reports current assets above noncurrent assets.

http://401kcalculator.org/

http://401kcalculator.org/

Types

Current assets include:

Understanding liquidity

Liquidity is defined as how easily an asset can be converted into cash. For example, short-term investments in stocks and bonds are considered to be very liquid because they can be sold by simply calling a stock broker. Accounts receivable are considered to be liquid because you can sell them to banks. On the other hand,  goodwill is not considered to be liquid because it is very difficult to sell.

Operating cycles

The actual definition of current assets is assets that are likely to be converted into cash within one year or one operating cycle, whichever is longer. An operating cycle is the period of time from when a company first buys inventory or raw materials, until the company actually collects cash from selling the finished product. Almost all companies have operating cycles of less than a year. And so the definition of current assets – for most companies – will be assets likely to be converted into cash within one year. However, some companies – such as wineries and ship builders – have much longer operating cycles. These companies define current assets as assets that are likely to be converted into cash within one of their operating cycles. For example, if it takes five years to grow grapes, turn them into wine, age the wine, and sell it, then the winery would have a five year operating cycle.

Productivity and Current Assets

All business assets should generate revenues and net income. Before purchasing any assets, think about how they will ultimately increase your profits. Also keep enough cash and short-term investments handy to pay your bills.

 

What are noncurrent assets?

Noncurrent assets are assets that are not deemed to be liquid enough to be converted to cash within one year or less. They are listed in the balance sheet below current assets.

Types of noncurrent assets

  • Property, plant, and equipment
  • Long-term investments
  • Goodwill
  • Copyrights, trademarks, and other intangible assets

Noncurrent assets and operating cycles

Noncurrent assets are assets that are likely to be converted into cash after one year or one operating cycle, whichever is longer. An operating cycle is the period of time from when a company first buys inventory or raw materials until the company actually collects cash from selling the finished product. Almost all companies have operating cycles of less than a year. And so the definition of current assets – for them – will be assets likely to be converted into cash within one year. However, some companies – such as wineries and ship builders – have much longer operating cycles. These companies define noncurrent assets as assets that are not likely to be converted into cash within one of their operating cycles. For example, a company that produces widgets (with an operating cycle of three months) defines noncurrent assets as assets likely to be converted into cash after one year. However, a winery that produces wine with an operating cycle of three years will define noncurrent assets as those likely to be converted into cash after three years.

Impairments of noncurrent assets

You should test noncurrent assets for impairment at least once a year, or whenever an event occurs that indicates that the asset may have lost value.

Property, plant, and equipment available for sale

If a company makes a decision to sell property, plant, and equipment, and the company believes that it will be able to sell the asset within a year (or an operating cycle, whichever is longer), then you can move the asset to the current assets section of the balance sheet.

Managing noncurrent assets

Take special care when making investments in noncurrent assets. The purpose of all business assets is to generate revenues and net income for a business. Avoid purchasing assets that might not deliver an adequate return. Sell or dispose of assets that are not being used productively.

 

Delete, Do it, Delegate, or Defer

Got too much work to handle? Take it one piece at a time, applying the four D’s: Delete, Do it, Delegate, or Defer.

In today’s workplace we constantly face a barrage of tasks. How do you prioritize them and get things done? Simple. Apply the four D’s! Whether you’re dealing with e-mail, snail mail, meetings, or tasks from your customers or your supervisor, any given problem can be reduced to this simple choice.

Delete

If it requires no action, then delete that e-mail. Got junk mail? Throw it away. One little twist on the “delete” option is the “file” option. I usually file informational e-mails away into separate folders. This might just be a waste of time, but it gives me the comfort of knowing that I’m keeping records.

Do it

If the task either requires immediate action, or you have the time to do it right now, then make like a pair of Nikes and just do it. Your boss walks into your office – give him or her a chair, sit down, and get the task done.

Delegate

If the task can or should be done by someone else, then hand it over to them. Don’t be a chronic delegator, who always seems to dole out tasks without doing anything themselves. And monitor whatever you delegate, to make sure that it is completed properly.

Defer

If a job will take a long time to complete, or is not terribly important, then defer it. In my first training as an accountant with a large accounting firm, we were taught to keep a draw with all of the unimportant jobs we are given. Put it all in the draw, and see if anyone asks for it. After a few months my drawer was full, and no one ever asked about anything that was in it.

Remember: Four D’s: Delete, Do it, Delegate, or Defer.

 

 

Accounting for cash and cash equivalents

Companies’ balance sheets report cash and cash equivalents. In this article, I explain what this means.

Defining cash

Cash is the standard medium of exchange, the basis for measuring and accounting for everything. It may consist of coins, currency, and funds available on deposit in a bank. It may also include petty cash balances on hand and money market accounts with checking privileges. Postdated checks are receivables, not cash.

Clarifying cash equivalents

Companies frequently invest cash into highly liquid investments in order to earn a tidy return. Cash equivalents are short-term, highly liquid investments that are both:

  1. readily convertible to known amounts of cash, and
  2. so near to their maturity that they present insignificant risk of changes in value caused by changes in interest rates.

In general, investments with original maturities of three months or less will qualify as cash equivalents. Here are some examples:

  • treasury bills
  • commercial paper
  • money market funds without checking privileges

On December 31, 2016, Apple reported that it had $10,669,000,000 worth of cash and cash equivalents. If this were invested in government securities yielding just 1% interest per year, Apple would earn more than $106 million in a single year!

Reporting cash and cash equivalents

Companies usually report cash and cash equivalents in the balance sheet as the very first current asset.

Journal entries

To increase cash and cash equivalents, debit it. To decrease it, credit it. To record receipt of cash from a sale, debit the account cash and cash equivalents, and credit the account sales revenue:

JE Sale for cash

To record a payment of cash for salary expense, debit the account salary expense and credit cash and cash equivalents, as shown here:

JE Pay salary expense

Take-away for entrepreneurs

You need to have enough cash and cash equivalents on hand to pay your bills in a timely basis, plus additional funds in case of an emergency or a financial opportunity that you wish to take advantage of. In general, keep enough cash in your checking account to pay all outstanding checks and the next few days’ worth of bills. Investing additional cash into cash equivalents – such as treasury bills and money market funds – will yield you a little extra interest income.

 

Computing and interpreting inventory turnover

Inventory turnover measures how productively a company uses its merchandise inventory to generate sales and profits.

Calculating inventory turnover

Here is the formula for inventory turnover:

Inventory turnover = Cost of goods soldAverage inventory

Cost of goods sold measures the amount paid to purchase or manufacture items that were sold during the period. To find cost of goods sold, look to the second or third line item in the company’s income statement (or statement of operations). It is sometimes referred to as cost of sales.

To compute average inventory, divide the sum of beginning inventory and ending inventory by two:

Average inventory = (beginning inventory + ending inventory) / 2

Beginning inventory is the value of inventory at the end of last year. It is listed in the balance sheet under current assets. Identify the balance of inventory not at the end of the current year, but rather at the end of last year – it is usually found in the last column on the right. Note that inventory is sometimes referred to as merchandise inventory.

Ending inventory is the value of inventory at the end of this year. It appears on the balance sheet under current assets, the second-to-last column on the right.

Technical note: a more accurate way to calculate average inventory is to add inventory at the beginning of the first quarter to inventory at the end of each quarter during the year. Then divide by five.

Example

In 2016, Macy’s had cost of goods sold of $16,496. The company’s beginning inventory in 2016 was $5,417. Its ending inventory was $5,506.

Average inventory = ($5,417 + $5,506) / 2 = $5,462

Inventory turnover = $16,496 / $5,462 = 3.02

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Interpreting inventory turnover

Successful businesses rely on using their merchandise inventory to generate sales and profits. After all, merchandise inventory is an investment, like any other asset. It needs to generate profits. Too much inventory requires a greater investment – and maybe even more debt – and can result in unsold, obsolete, or spoiled goods. Stocking too little inventory can cause you to lose sales. After all, customers who can’t find what they’re looking for will shop elsewhere.

Inventory turnover describes how many times, on average, inventory “turns over” each year. Visualize a shelf with widgets. If the widgets have turnover of 4.0, that means that on average the company will stock and then sell all of its widgets four times a year. Higher turnover indicates that the company’s inventory is purchased and sold relatively quickly. It’s flying off the shelves. Lower turnover indicates that it takes a longer time for the company to sell its inventory.

Example

Macy’s inventory turnover is 3.02. Wal-Mart’s inventory turnover for the same period was 8.06. Wal-Mart’s higher inventory turnover indicates that the company sells its inventory more than twice as quickly as Macy’s.

Number of days’ inventory

Number of day’s inventory provides the same basic information as inventory, but in an easier-to-interpret figure. It indicates how many days – on average – it takes a company to sell inventory. Here’s the formula:

Number of days’ inventory = 365 / inventory turnover

For simplicity sake, some people may use the number 360 in the numerator instead of 365.

Example

As I note above, Macy’s inventory turnover is 3.02. The company’s number of days’ inventory equals 365 / 3.02 = 120.9. This means that on average it takes about 121 days from when Macy buys inventory and when it sells it. On the other hand, Wal-Mart’s inventory turnover is 8.06. Its number of day’s inventory equals 365 / 8.06 = 45.3. On average, only 45 days pass between when the company first buys inventory and when it sells it. Clearly, Wal-Mart makes more productive use of its inventory investment than Macy’s. Visualize inventory flying off the shelves of a Wal-Mart store, while it sits in the racks at Macy’s, waiting to be purchased.

Lesson for entrepreneurs

Use inventory turnover or number of days’ inventory to keep your inventory levels productive. Monitoring these ratios will help to ensure that you’re not stocking too much or too little inventory.

 

Accounting for merchandise inventory

Inventory, also called merchandise inventory, is the company’s investment in products that it plans to sell to customers. It is an asset recorded on the balance sheet along with other current assets. Manufacturers make their own inventory, while retailers and other businesses buy their inventory from suppliers.

Recording inventory

Under U.S. Generally Accepted Accounting Principles, companies usually record inventory at the lower of cost or market value. This means that they record inventory at its original cost unless its market value is lower than cost.

To determine the cost of its inventory, companies must use a cost flow assumption. The four most common techniques for computing the cost of inventory are:

  1. First-in first out (FIFO),
  2. Last-in first out (LIFO),
  3. Weighted Average (also known as Moving average), and
  4. Specific identification.

To keep track of inventory costs, companies use either periodic or perpetual inventory systems. In a periodic inventory system, a company physically counts its inventory at the end of each year. To compute cost of goods sold, it uses the following formula:

Cost of goods sold = beginning inventory + purchases – ending inventory

(Note that the beginning inventory would be the same as the ending inventory last year.)

In a perpetual inventory system, a company continuously keeps track of the balance of all of its inventory activity. Every sale of every item is recorded, so that the company has a record of how many goods are in stock at any given time. Cost of goods sold is calculated based on the actual number of units that the company recorded as sold during the period.

To record a purchase of inventory, debit the account “inventory.” If you’re purchasing on credit, then credit the account “accounts payable.” Otherwise, if you’re paying for it now, credit the account “cash.” Here’s an example of purchasing inventory on credit for $1,000:

JE Purchase inventory

 

Update to Accountinator Spreadsheet

I’ve posted an updated version of the Accountinator spreadsheet.

If you already use the existing spreadsheet and get inappropriate “oops” cells, then you may wish to update to this new version. You can copy and paste your existing data into the new version, or copy the “oops” cells in column “A” from the new version into your existing document.

https://accountinator.com/wp-content/uploads/2015/05/accountinator-spreadsheet-v2.01.xlsx