Revenue and Expenses

Jacqueline Gagnon

4 Revenue and Expenses

Income Statement Fundamentals

Jacqueline Gagnon

Ratio Analysis: Evaluating Profitability

A lightbulb brain in a circle—the 'think' section of the think-see-do approach.

The income statement offers great opportunity for ratio analysis. Remember that we have three income measures: Gross Profit, Operating Income, and Net Income. And each of these income measures tells us how much of our sales is available to pay for remaining costs plus a return to shareholders. Profitability ratios present this information as a percentage: the percentage of sales left over at each profit stop-point. Not surprisingly, financial statement users will want to see a high profitability.

Gross MarginGross Margin: The percentage of sales leftover after paying cost of goods sold. Gross margin is calculated as gross profit divided by sales.: is the percentage of sales that ends up in gross profit, or the percentage left over after paying cost of goods sold. We can think of gross margin as the percentage of sales leftover to pay all non-product-related expenses and contribute a return to shareholders.; $\begin{equation*} \textbf{Gross Margin}\;=\;\frac{\text{Gross Profit}}{\text{Sales}} \end{equation*}$
Operating MarginOperating Margin: The percentage of sales that remains in operating income. Operating margin is calculated as operating income divided by sales.: is the percentage of sales that ends up in operating income, or the percentage left over after paying COGS and operating expenses. We can think of operating margin as the percentage of sales left over to pay for peripheral items and income taxes, and then contribute a return to shareholders.; $\begin{equation*} \textbf{Operating Margin}\;=\;\frac{\text{Operating Income}}{\text{Sales}} \end{equation*}$
Profit MarginProfit Margin: The percentage of sales that remains in net income and therefore belongs to shareholders. Profit margin is calculated as net income divided by sales.: is the percentage of sales that end up in net income, or the percentage left over after all expenses. We can think of profit margin as the percentage of sales that belong to shareholders.; $\begin{equation*} \textbf{Profit Margin}\;=\;\frac{\text{Net Income}}{\text{Sales}} \end{equation*}$

An eye in a circle—the 'see' section of the think-see-do approach.

Each of these profitability ratios is constructed the same way: income measure ÷ sales. But they tell a slightly different story. Let’s look at some examples.

My Turn: Let’s look back at Hose Ltd. Hose had sales revenue of $1,725,500; gross profit of $969,500; operating income of $499,500; and net income of $370,000. Therefore, Hose’s profitability can be analysed as follows:
Gross Margin: $\begin{equation*} \frac{\text{Gross Profit}}{\text{Sales}}\;=\;\frac{\$\,969,500}{\$\,1,725,500}\;=\;\bf{56\%} \end{equation*}$; This means that 56% of sales revenue is available to pay all expenses (operating and non-operating) and to provide a return to shareholders.
Operating Margin: $\begin{equation*} \frac{\text{Operating Income}}{\text{Sales}}\;=\;\frac{\$\,499,500}{\$\,1,725,500}\;=\;\bf{29\%} \end{equation*}$; This means that 30% of sales revenue is available for remaining expenses and income taxes, and to provide a return to shareholders. This is the return from operating the business model.
Profit Margin: $\begin{equation*} \frac{\text{Net Income}}{\text{Sales}}\;=\;\frac{\$\,370,000}{\$\,1,725,500}\;=\;\bf{21\%} \end{equation*}$; This means that 21% of sales revenue is available to shareholders as a return on their investment.

A gear and a pencil in a circle—the 'do' section of the think-see-do approach.

Again, it’s your turn to try!

Your Turn:4—5: Lemon Squeezy

Solution:4—5: Solution

4 Revenue and Expenses

Ratio Analysis: Evaluating Profitability

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