LDP 3.3 Analyzing the Income Statement

Question 1

Gross Profit Margin

Answer 1

Gross Profit / Net Sales

• measures how much profit is left in each sales dollar after satisfying cost of goods sold, expressed as a percentage of net sales.

How is it interpreted?

• An important measure of profitability because cost of sales represents, for most companies, the largest portion of expenses that management must control for the company to succeed
• Reflects the company’s success in responding to competitive challenges in its market, through its pricing strategy

Question 2

Operating Expense Ratio

Answer 2

Total Operating Expenses / Net Sales

• tells us how effectively a company is managing expenses to protect its gross profit.

How is it interpreted?

• The operating expense ratio tells us how effectively a company is managing expenses to protect its gross profit
• Operating expense ratio trends often tell a great deal about management ability

Question 3

Operating Profit Margin

Answer 3

Operating Profit / Net Sales

Studying reasons for change in margin helps you isolate causes of and changes in profitability.

Question 4

Pretax Profit Margin

Answer 4

Profit Before Tax / Net Sales

How is it interpreted?
Good for trend analysis and external comparisons because it eliminates the effect of tax strategies and extraordinary income or expense

Question 5

Net Profit Margin

Answer 5

Net Income / Net Sales

Measures the overall profitability of a company after all income and expense items have been accounted for

Question 6

Operating Leverage

Answer 6

• The degree to which a company’s expenses are fixed expenses
• Changes in a company’s sales volume can indirectly impact its gross profit margin, especially for manufacturing companies. If sales volume drops, the company’s fixed costs will represent a higher proportion of sales dollars than before, so that each sale will become less profitable. Conversely, when sales volume increases, the fixed costs will represent a lower proportion of sales dollars than before, so each sale will become more profitable.

Question 7

Fixed costs:

Answer 7

• Remain constant in total throughout the range of sales activity in which company expects to operate
• Examples include property taxes, hazard insurance, and office staff salaries

Question 8

Variable costs:

Answer 8

• Change in total in direct proportion to changes in activity

Examples include raw or direct materials, direct labor, and cost of goods sold

Question 9

Mixed costs:

Answer 9

Contain both a variable and a fixed element

Question 10

Three key measures for analyzing a company’s operating leverage

Answer 10

1) Contribution Margin %
2) Break-Even Point
3) Degree of Operating Leverage % (DOL)

Question 11

Contribution Margin %

Answer 11

(Sales - Variable expenses) / Sales

Enables analyst to easily compute customer break-even point, or how many sales dollars are required to exactly cover fixed expenses.

• For example, if a company’s sales are $800,000 and its variable expenses are $400,000, its contribution margin percent is 50%. Half of this company’s sales are available to help cover its fixed expenses.

Question 12

Break-Even Point

Answer 12

Fixed expenses / Contribution margin %

Fixed Costs/Price - Variable Costs
The higher the contribution margin, the lower the break-even point

Key to sustained profits is ability to minimize the variable cost component of each sale dollar and to exercise discipline over fixed expenses

Question 13

Degree of Operating Leverage % (DOL)

Answer 13

(Sales – Total variable expenses) / (Sales – Total expenses)

• enables you to identify the percentage increase in operating profit that will result from an increase in sales.
  Illustrates potential profit advantage of company with high fixed costs compared to variable costs

Question 14

Degree of Operating Leverage Sample:

Answer 14

Assume the company’s sales are $800,000, with total expenses of $700,000, of which
$400,000 are variable. This means that its DOL equals four. The DOL is computed by subtracting
$400,000 from $800,000 in the numerator of the DOL equation and subtracting $700,000 from
$800,000 in the denominator of the equation. This equals $400,000 divided by $100,000. If the
company’s sales were to grow by 10%, the expected increase in operating profit would be 10
times 4, or 40%. Conversely, if the company’s sales decreased by 10%, operating profit would
fall by 40. Click the Notepad icon to see how sales volume impacts this company’s profit.