Calculation Of Gross Profit, Operating Profit, And Net Profit

Calculation of Gross Profit

Preparation of income statement for Sandifer Manufacturing Company.

Net profit of the firm for the year is $ 472,000. Net profit of the company is the ultimate profit which is left after paying all the direct and indirect expenses and tax liability of the company. The net profit can be used either to distribute dividend or for the extension of the company. The extension of company can be referred as purchasing assets or starting new production line or it can be used to increase the liquidity of the company for the next year. The dividend distribution is must so some part of it has to be distributed as dividend to the shareholder as they are expecting some return from their investment in the company.  

The gross profit is calculated first and then after that all the other profits are derived after making necessary subtraction and addition to the gross profit (Mathuva, 2015). The Gross Profit is derived after subtracting all the expenses related expenses like raw material cost and their ancillary expenses from the sales made in the year both credit and cash. Therefore cost of goods sold is subtracted from sales to calculate Gross profit. In the above case Gross profit is $ 112,500.

Operating profit is calculated from Gross profit after subtracting all the other expenses that are related to business such as electricity, depreciation, loss on investments and others. It means the profit available before tax (Wales, et. al., 2013).

Net profit is the ultimate profit that is distributed to the shareholders or preference share holders after providing tax at the applicable tax rate. This profit does not include any expenses at it is the last stage of calculating profit.

From the above information it can be derived that the Sandifer Manufacturing Company is earning net profit at a rate of 10.5% from the revenue made throughout the year. The company is earning a suitable rate of return over the turnover by operating in a manufacturing industry. The gross profit percentage of the year is 25% and the operating profit percentage is 15%. The main part of expense includes cost of goods sold which is 75% percentage of the total turnover.

 In the above solution profit available for distribution for dividend is $ 472,500

If the company is proposing to invest $ 50,000 back to its firm than the profit available for the shareholder as dividend will be as follows:

Calculation of Operating Profit

• Liquidity of a company means the capacity of the company to arrange cash by selling the assets in the open market. The cash arises from sale should not be below the market value (Campello, et. al., 2011). Liquidity is the total of cash and cash equivalent assets of the company. Example of liquid assets is bank account, short term investments, investment in securities, stock in trade.
• The different types of ratios that is used to measure the liquidity of the organization are as follows :
• Current ratio: it is calculated by dividing the current assets with current liability.
• Quick ration: It is calculated by dividing the quick asset with current liabilities.
• Cash ratio: It is calculated by dividing the cash and cash equivalent with the current liabilities (Adrian & Shin, 2010).
• Calculation of new current ratio :

The liquidity can be checked by comparing the liquid ratio of King Carpet Company with the liquid ratios of other company. If the liquid ratio is more than the liquid ratio of other companies in the market than the King Carpet Company is more liquid than other companies, but if this ratio is less than ratio of other companies than the liquidity is less than other companies in the market.

Computation of company’s operating profit and net profit.

• There are many ways of determining the reasonable profit margin of the company. A company should compare the profit margin with the average profit margin of the other companies in the same industry. Some different logical ways for calculation of profit margin are follows :
• Break even analysis: this concept state that the minimum profit of the company should be equal to the total of fixed and variable cost of the company.
• Weighted average cost of capital: It emphasis on the concept that the company should earn that percentage of profit which is sufficient to pay all the cost of capital of the company such as cost of equity, debt etc (Arrow & Kruz, 2013).
• Return on asset :

Formula Return on assets = Net Profit / Total assets

= ($ 4,620,000 / 42,000,000) * 100

= 11%

Formula for Return on Equity = Net Profit / Total Equity

= ($ 4,620,000 / $ 22,000,000) * 100

= 21%

These ratios measure the profitability of the company. The capacity of the company to pay back on the amount invested in the company (Bradford, et. al., 2013).

Formula for calculation of compound interest :

Amount = P (1 + R/100) ⁿ

 75,000 = 50,000 (1 + 7 / 100) ⁿ)

1.5 = (1 + .07) ⁿ

1.5 = (1 .07) n

Number of year using the future value table is 6 years. It will take 6 years for $ 50,000 to grow into $ 75,000 at 7% rate.

Formula for calculation of compound interest :

Amount = P (1 + R/100) ⁿ

Amount = 50,000 (1 + .07)^10.25

Amount = 50,000 (2.105)

Amount = $ 105,250

At the end of 10.25 year $ 105,250 will be received.

Note: interest is compounded annually at the last of the year therefore .25 year is not taken into consideration.

Formula for calculation of compound interest :

Amount = P (1 + R/100) ⁿ

 75,000 = 50,000 (1 + 3 / 100) ⁿ)

1.5 = (1 + .03) ⁿ

1.5 = (1 .03) n

Number of year using the future value table is 6 years. It will take 14 years for $ 50,000 to grow into $ 75,000 at 3% rate.

Formula for calculation of compound interest :

Amount = P (1 + R/100) ⁿ

 75,000 = 50,000 (1 + 11 / 100) ⁿ)

1.5 = (1 + .11) ⁿ

1.5 = (1 .11) n

Number of year using the future value table is 6 years. It will take 4 years or it can be said those 3.5 years for $ 50,000 to grow into $ 75,000 at 11% rate.  

Calculation of Net Profit

The interest rate in the account is high than the sum will grow at increasing rate over the years, therefore the required amount can be saved within short time as compared to the accounts in which the rate of interest is low. Therefore it can be said that when the amount is same than the number of year will increase if the rate will decrease and vice versa. There is inverse relationship between the number of year and rate of interest (Whicher, et. al., 2011).

Calculation of amount to be invested by Sarah

Required amount = $ 2,000,000

Rate of interest = 4%

Time = 35 years

Formula of compound interest

Amount = P (1 + r / 100) ⁿ

2,000,000 = P (1 + 0.04)³⁵

P = 2,000,000 / (4.104)

P = 487,330

Therefore, Sarah has to invest $ 487,330 today to get $ 2 million at the end of 35 year with the interest rate of 4%. 

Calculation of years in which $ 487,330 will grow to $ 2 million at an interest rate of 14%.

Formula of compound interest

Amount = P (1 + r / 100) ⁿ

2,000,000 = 487,330 (1 + 0.14) n

2,000,000 / 487,330 = (1.14) n

4.10 = (1.14) n

N = 10 years

Sarah will be able to retire in 10 years if she can earn 14% and invest $ 487,330 today.

Calculation of rate of return

Rate of return = total reward / value of the investment at the time of purchase

Calculation of total reward

Calculation of rate of return:

= (-3.16 / 5.75) * 100

= -55%

Rate of return is negative because there is loss.

• The concept of realized return is introduced to calculate the return from an investment over a given period of time. The realized return takes into consideration all the benefit that is derived from the investment such as profit or loss from the sale of investment and any dividend or interest received from that investment etc. the realized return can be calculated for the period for which the investment is being held, this can be more than one year or operating cycle of the company.
• The cash dividend received from an investment will affect the realized rate of return as the cash dividend received will form the part of benefit received from the company (Bradford, et. al., 2013). The value of investment can increase over a period, if the value is increase than this will be profit but if the value will decrease then it will turn out to be a loss. This profit or loss be added to the dividend received from such investment if realized rate of return is calculated.
• The investment is made with the purpose of earning some return over and above the investment. The return is usually the reward of the risk which the investor took while investing in such investment. The return from the investment is not same every year. Some year it is high other year it can be low, this change is due to the market change. The risk of an investment can be calculated recognizing the pattern of the investment with the change in market. Beta and Standard deviation is used to calculate the risk of an investment.

Calculation of rate of return earned:

Rate of return = total reward / value of the investment at the time of purchase

Calculation of total reward

Calculation of rate of return:

= (-2840.192 / 6615.2) * 100

= -42%

Rate of return is negative because there is a loss.

Mathuva, D. (2015). The Influence of working capital management components on corporate profitability.

Wales, W. J., Parida, V., & Patel, P. C. (2013). Too much of a good thing? Absorptive capacity, firm performance, and the moderating role of entrepreneurial orientation. Strategic Management Journal, 34(5), 622-633.

Campello, M., Giambona, E., Graham, J. R., & Harvey, C. R. (2011). Liquidity management and corporate investment during a financial crisis. The Review of Financial Studies, 24(6), 1944-1979.

Adrian, T., & Shin, H. S. (2010). Liquidity and leverage. Journal of financial intermediation, 19(3), 418-437.

Arrow, K. J., & Kruz, M. (2013). Public investment, the rate of return, and optimal fiscal policy (Vol. 1). Routledge.

Bradford, W., Chen, C., & Zhu, S. (2013). Cash dividend policy, corporate pyramids, and ownership structure: Evidence from China. International Review of Economics & Finance, 27, 445-464.

Whicher, A., Raulik?Murphy, G., & Cawood, G. (2011). Evaluating design: Understanding the return on investment. Design Management Review, 22(2), 44-52.

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