From Sales to Profit - aka costs of running a business
Posted: 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.
from sales, the business's costs are deducted. I've come across 3 very general categories of these:
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).
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.
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).
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
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