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From Sales to Profit - aka costs of running a business

Analysing companies' finances and value from their financial statements using ratios and formulae
TheMotorcycleBoy
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From Sales to Profit - aka costs of running a business

#190436

Postby TheMotorcycleBoy » January 1st, 2019, 5:10 pm

Hi all,

In my attempts to read and analyse financial statements from various UK-(and Isle of Man) -domiciled companies I have encountered various presentations of income statement, with a lot of commonality, but one or two differences. What I have been trying to think of lately is all the different types of costs and taxes, and also the different types of profit measurement. While I think about it, I decided to write my thoughts down, so thought I'd share them here, and I'd appreciate any comment, criticism, additions etc.

+-------------------------------------+
| SALES, calculated on accruals basis |
+-------------------------------------+

from sales, the business's costs are deducted. I've come across 3 very general categories of these:

+-------------------------------------+
| CoGS |
+-------------------------------------+
| SD&A |
+-------------------------------------+
| R&D |
+-------------------------------------+

1. CoGS - costs of goods sold. Basic production costs. This is the cost of the raw materials, salaries, income tax (as deducted from salaries), NI contributions, cost of electricity, rent, leases etc. (I'm not sure whether "capex" is included here, I believe cost of investments in long-lived machinery, vehicles, etc. doesn't appear in P&L statement directly but is apparent in money movements in the balance sheet i.e. appearance of debt or disappearance of cash, and corresponding appearance of additional fixed asset values).

2. SD&A - sales, distributions, admin. (Sometimes called SGA, G being "general"). These are non-production costs, i.e. the delivery costs, cost of the sales staff (so presumably there is a wages/income-tax contribution from here as well as above), cost of the accounts, HR, marketing etc.

3. R&D - research and development. These are usually only applicable to certain types of firm, e.g. semi-conductor (e.g. micro-processor designers), drug manufacture, hi-tech engineering. Some companies can be a bit sneaky and attempt to "capitalise" these costs - i.e. they vanish from the P&L statement, and appear on the Fixed assets part of the Balance Sheet as intangibles, and presumably are slowly amortised.

After the above costs are deducted we are left with EBITDA (earnings before interest, tax, depreciation and amortisation). I think some people also call this value "Gross profit", though I may be wrong. (i.e. feel free to confirm).

+-------------------------------------+
| EBITDA |
+-------------------------------------+

From the above EBITDA (is this "Gross Profit?"), the DA bit (depreciation and amortisation) is now subtracted. This is a weird bit because it is not a here-and-now cash reduction, but an estimate of how much certain fixed assets have lost in value in the past accounting period. It is interesting because in addition to reducing apparent headline profits, it also reduces how much profit will be taxed, without reducing cash flow. After subtracting the DA portion, what is left is "Operating Profit", or EBIT.

+-------------------------------------+
| EBIT - Operating Profit |
+-------------------------------------+

The next subtraction which is made is due to the company (if it has any borrowings) paying off any interest on those borrowings. What I'm slightly unclear about is whether the company reduces operating profit above by just the "interest it owes" or the result of "interest owing - interest earned" i.e. "net interest" because if the firm has money in the bank, then it will have earnt money under interest.

I'm assuming that the interest part in EBIT means net interest, otherwise, for example, a firm with £5m sales, £3m cost, which has £1m in interest payments owing and has earnt £1m in interest income, could effectively halve their tax bill by paying tax on £1m remaining, rather than actually £2m of total earnt monies (from their day-to-day business and from interest on money in the bank), than if their interest income too, is correctly taken into account.

After subtracting the interest charge we are now left with Profit before Tax, or PBT (EBT - earnings before tax).

+-------------------------------------+
| PBT - Profit before Tax |
+-------------------------------------+

The final deduction made to the above is that of Corporation Tax, i.e. not (employee's) income tax. This leaves Profit After Tax (PAT), net income, net earnings, or Profit for the year - using some of the various terminologies that I've encountered.

Does all the above sound correct?
Matt

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Re: From Sales to Profit - aka costs of running a business

#190986

Postby FoolishRix » January 4th, 2019, 11:24 am

No-one else has answered so I'll have a go.
Bear in mind I'm not an accountant and my experience is 30 years running an small tech business (not a quoted company with a roomful of creative financial advisers).

When I was at business school (admittedly a long time ago) I learnt that
Gross Profit = sales - COGS
ie. the direct cost of achieving those sales - no variable costs are included.
This is how I use it in our business.
It is significant for reasons that are set out below.

Yes, the interest part in EBIT is net interest as any interest income must be shown in the P&L.

The rest of what you have said sounds good to me.

GP (aka 'gross margin') as calculated above is important (to me) because:
- take GM and convert it to a percentage of sales (to get GM%)
- then divide FixedCosts (ie. in your example SDA + R&D) by GM%
and you get breakeven.

Breakeven is, for me, useful in tracking our performance on a monthly basis throughout the year (rather than relying on EOY accounts).
It tells me if we need to increase GM, work harder or, similarly, can relax a little...

Other people may have different views but this has worked for me.

TheMotorcycleBoy
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Re: From Sales to Profit - aka costs of running a business

#191067

Postby TheMotorcycleBoy » January 4th, 2019, 4:28 pm

FoolishRix wrote:No-one else has answered so I'll have a go.
Bear in mind I'm not an accountant and my experience is 30 years running an small tech business (not a quoted company with a roomful of creative financial advisers).

Many thanks for jumping to this thread, FoolishRix. This bit is interesting:

FoolishRix wrote:When I was at business school (admittedly a long time ago) I learnt that
Gross Profit = sales - COGS
ie. the direct cost of achieving those sales - no variable costs are included.
This is how I use it in our business.
It is significant for reasons that are set out below.
....
GP (aka 'gross margin') as calculated above is important (to me) because:
- take GM and convert it to a percentage of sales (to get GM%)
- then divide FixedCosts (ie. in your example SDA + R&D) by GM%
and you get breakeven.

Breakeven is, for me, useful in tracking our performance on a monthly basis throughout the year (rather than relying on EOY accounts).
It tells me if we need to increase GM, work harder or, similarly, can relax a little...

Thank you!

FoolishRix wrote:Yes, the interest part in EBIT is net interest as any interest income must be shown in the P&L.

Again - thanks for confirming this.

As you've noted above, I was at pains to differentiate CoGs, SD&A and R&D

https://www.investopedia.com/terms/c/cogs.asp
https://www.investopedia.com/terms/s/sga.asp
https://www.investopedia.com/terms/r/re ... penses.asp

my rationale for doing this is that I have been using Earnings Power Value (EPV) as a valuation technique as learnt from this book. And using that methodology, one assumes that the company does not grow, and hence any (estimated) portion of growth related costs (e.g. SDA or R&D) are added back to the EBIT. However, as I hinted in my OP, more and more firms in their ARs seem to capitalise the cost of R&D, so that they, essentially, add it back themselves.

The other point which you may have noted, is that I laboured to differentiate between how corporation tax and the other types of tax treated....i.e. the effect of the "other types" is seen the above costs, whereas it is the applicaton of corporation tax that reduces PBT to PAT.

many thanks
Matt

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Re: From Sales to Profit - aka costs of running a business

#191748

Postby FoolishRix » January 7th, 2019, 5:40 pm

However, as I hinted in my OP, more and more firms in their ARs seem to capitalise the cost of R&D, so that they, essentially, add it back themselves.

That's a new one on me and I cannot really think why you would do that (other than to save them up to apply for future R&D tax credits).
The ability to write-off R&D costs against income (in the P&L) is good as it means that we reduce our taxable profit and don't carry those R&D costs forward (with the consequent hassle of depreciating them in future years).

TheMotorcycleBoy
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Re: From Sales to Profit - aka costs of running a business

#191865

Postby TheMotorcycleBoy » January 8th, 2019, 8:10 am

FoolishRix wrote:
However, as I hinted in my OP, more and more firms in their ARs seem to capitalise the cost of R&D, so that they, essentially, add it back themselves.

That's a new one on me and I cannot really think why you would do that (other than to save them up to apply for future R&D tax credits).
The ability to write-off R&D costs against income (in the P&L) is good as it means that we reduce our taxable profit and don't carry those R&D costs forward (with the consequent hassle of depreciating them in future years).

Hi FR,

Well I'm fairly new to figuring out corporate accounts, but I guess that if you have private company, then it makes sense to reduce profits as much as possible so that you pay less tax. But for a public listed company, I imagine the situation to be complicated by the fact that profits and operating margins are visible to the investing public, and may perceived as a barometer of the company's value. In fact it is no secret that in the past firms have indulged in creative accounting in order to raise their quoted EPS.

If you have the time take a gander at this where I highlighted a firm's books that I've recently processed and can illustrate the accounting practice that you refer to above.

I first read about this practice in this book.

catch you later,
Matt


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