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Financial Theory

  • A hypothecation agreement allows a broker-dealer to

    A. approve the client for "hot" IPOs.

    hold the margined securities in a street name loan - using the securities as collateral for other means (i.e. bank loans and short sales of other customers).

    C. hold margined securities in mutual fund accounts and keep the dividends.

    D. invest the client's proceeds from hypothetical dividends.

    Answer: B
    The Hypothecation agreement is an addendum to the margin agreement, and more often than not, is required by broker-dealers.

  • Are accounts payable an expense?

    Accounts payable is a liability, not an expense. The two represent related but ultimately different concepts. The balance of accounts payable is commonly included in total expenses when reviewing a company's financial statements. The best way to understand how to distinguish between liabilities and expenses is by analyzing past versus future actions; liabilities are those obligations that are yet unpaid, while expenses are obligations that have already been paid in an effort to generate revenue.

    Liability Account Vs. Expense Account

    Liability and expense accounts both appear on financial statements. Liabilities are covered on the balance sheet, which shows a snapshot of a company's financial standing for a specific date. Expenses show up on the income statement. The income statement itemizes revenues and expenses to show net income for a period of time.

    An example of an expense transaction would be any cost that might be incurred while a salesperson is trying to bring in revenue. Lodging, client dinners, transportation and materials for presentations are all added to the expense account.

    Liability accounts are any costs incurred that haven't yet been paid. These include interest owed on loans from creditors (interest payable) and taxes that have built up that the company expects to have to pay (taxes payable).

    Accounts payable involves any money owed to creditors that will come due in a short period of time – usually less than 30 days – that doesn't involve a promissory note. A mortgage obligation wouldn't be added to accounts payable because it came with a promissory note; mortgage obligations fall under notes payable.

  • Are all fixed costs sunk costs?

    In accounting, finance and economics, all sunk costs are fixed costs. However, not all fixed costs are considered to be sunk. The defining characteristic of sunk costs is that they cannot be recovered. It's easy to imagine a scenario where fixed costs are not sunk; for example, equipment might be resold or returned at purchase price.

    Individuals and businesses both incur sunk costs. For example, someone might drive to the store to buy a television, only to decide upon arrival to not make the purchase. The gasoline used in the drive is a sunk cost – the customer cannot demand that the gas station or the electronics store compensate him for the mileage.

    Fixed and Sunk Costs for Business

    Businesses generally pay more attention to fixed and sunk costs than individual consumers. For businesses, fixed costs include anything that must be paid for production to occur, yet they remain the same whether production is high or low.

    In financial accounting, sunk costs must have already occurred, and they cannot be changed or avoided in the future. This does not apply to rental equipment; rental costs are only fixed until the renter decides to discontinue use.

    Costs are considered sunk even if an item is never completely used. Suppose a company, SMR Producers, purchases a machine for $5,000 with an expected useful life of five years. Using straight-line depreciation, the company should recognize $1,000 in depreciation expense per year. If, after three years, the company gets rid of the machine, the remaining book value, $2,000, must be written off.

    Even though only $3,000 worth of accounting use came from the machine, the full $5,000 was initially paid and is considered sunk.

    Variable Sunk Costs

    In a certain sense, some sunk costs begin as variable costs. Once a variable cost is incurred and cannot be recovered, however, it is necessarily fixed in sunk terms. By definition, $1,000 worth of variable costs are sunk if they cannot be recovered; once incurred, the realized sunk costs become fixed.

  • Are companies with a negative return on equity (ROE) always a bad investment?

    Companies that report losses are more difficult to value than those that report consistent profits. Any metric that uses net income is basically nullified as an input when a company reports negative profits. Return on equity (ROE) is one such metric. However, not all companies with negative ROEs are always bad investments. 

    Reported Return on Equity

    ROE is calculated as:

    Net income / Shareholders’ equity   

    To get to the basic ROE formula, the numerator is simply net income, or the bottom-line profits reported on a firm’s income statement. The denominator for ROE is equity, or more specifically – shareholders’ equity.

    Clearly, when net income is negative, ROE will also be negative. For most firms, an ROE level around 10% is considered strong and covers its costs of capital.

    How it can Mislead

    A firm may report negative net income, but it doesn’t always mean it is a bad investment. Free cash flow is another form of profitability and can be used in lieu of net income. Below is an example of how looking only at net income can be misleading.

    Back in 2012, computer and printing giant Hewlett-Packard Co (HPQ) reported a number of charges to restructure its business. This included headcount reductions and writing down goodwill after a botched acquisition. These charges resulted in negative net income of $12.7 billion, or negative $6.41 per share. Reported ROE was equally dismal at -51%. However, free cash flow generation for the year was positive at $6.9 billion, or $3.48 per share. That’s quite a stark contrast from the net income figure that resulted in a much more favorable ROE level of 30%.

    For astute investors, this could have provided an indication that HP wasn’t in as precarious position as its profit and ROE levels indicated. Indeed, the next year net income returned to a positive $5.1 billion, or $2.62 per share. Free cash flow improved as well to $8.4 billion, or $4.31 per share. The stock rallied strongly as investors started to realize that HP wasn’t as bad an investment as its negative ROE indicated.    

    The Bottom Line

    The HP example demonstrates how looking at the traditional definition of ROE can mislead investors. Other firms chronically report negative net income, but have healthier free cash flow levels, which might translate into stronger ROE than investors could realize.

    At the time of writing, Ryan C. Fuhrmann did not own shares in any of the companies mentioned in this article.

  • Are depreciation and amortization included in gross profit?

    Gross profit is the revenue earned by a company after deducting the direct costs of producing its products. For example, if it costs $15,000 to produce a car, and the car sells for $20,000, the difference of $5,000 is the gross profit on that one car. Gross profit, sometimes referred to as gross margin, is a company's total revenue after subtracting the cost of goods sold.  

    Typically, depreciation and amortization are not included in gross profit and are treated as separate line items on an income statement. However, there are situations wherein depreciation is included in the cost of goods sold, which is used in calculating gross profit. Below are the two main components of gross profit; revenue and cost of goods sold.

    Components of Gross Profit

    Revenue is the total amount of income generated from sales in a period. Revenue is also called net sales because discounts and deductions from returned merchandise may have been deducted.

    Cost of goods sold is the direct costs associated with producing a company's goods. Cost of goods sold or COGS includes both direct labor costs and any costs of materials such as raw materials used in producing a company's products.

    Gross profit measures how effectively a company generates profit from their direct labor and direct materials. Gross profit does not include non-production costs. Only the costs and profit associated with the production facility or factory are included in gross profit. Some of these costs include:

    • Direct materials
    • Direct labor
    • Equipment costs involved in production
    • Utilities for the production facility
    • Shipping costs

    Depreciation and Amortization

    As stated earlier, in most cases, depreciation and amortization are treated as separate line items on an income statement. Amortization technically refers to intangible assets, such as a patent. Depreciation is typically used with fixed assets or tangible assets, such as physical property, plant, or equipment.

    Below is a portion of the income statement for J.C. Penney Company Inc. (JCP) as of May 5, 2018.

    • Total revenue is highlighted in green for the amount of $2.67 billion, while the COGS is beneath revenue, coming in at $1.7 billion.
    • Depreciation and amortization of $141 million are listed separately, highlighted in blue below. 
    • For J.C. Penney, gross profit for the period would include revenue and COGS. Depreciation and amortization would not be used in the gross profit calculation, but instead would be included in operating income, which is further down the statement, totaling $2.66 billion for the period.

    The source of the depreciation expense determines whether the expense is allocated between cost of goods sold or operating expense. Some depreciation expenses are included in the cost of goods sold and, therefore, are captured in gross profit.

    For example, the depreciation of the building for the corporate office and its furniture would not be included in COGS because it's not a direct cost associated with the production of goods. However, a portion of depreciation on the manufacturer's plant or facility would be included in the overhead costs or fixed costs for the plant. As a result, that portion of depreciation might also be included in the costs of producing the goods or COGS because the depreciation is directly tied to the factory.

    It is much more rare to see amortization included as a direct cost of production, although some businesses such as rental operations may include it. Otherwise, amortized expenses are typically not captured in gross profit. Accounting treatment on income statements varies somewhat for each business and by industry.

  • Are dividends considered an expense?

    Cash or stock dividends distributed to shareholders are not considered an expense on a company's income statement. Stock and cash dividends do not affect a company's net income, and they represent part of a company's retained earnings returned to a company's shareholders. While cash dividends reduce the overall shareholders' equity balance, stock dividends represent a reallocation of part of a company's retained earnings to the common stock and additional paid-in capital accounts.

    What Are Dividends?

    Because they do not represent a company's cash outflow necessary to conduct its business operations to sell goods and services, dividends are not part of the income statement and are not considered an expense. A company may have a dividend policy, which can be canceled at any time and not show up on a company's financial statements.

    Dividends Accounting

    Cash dividends represent a company's cash outflow that goes to its existing shareholders, and they are recorded through reduction of cash and retained earnings accounts. Because cash dividends are not a company's expense, they show up as a reduction of equity on the company's statement of changes in shareholders' equity. Cash dividends reduce the size of a company's balance sheet and its value since the company no longer owns part of its liquid assets.

    Stock dividends do not represent a cash flow transaction and are not considered an expense either. Companies distribute stock dividends to their shareholders in certain proportion to common shares outstanding. Stock dividends reallocate part of a company's retained earnings to the common stock and additional paid-in capital accounts, and they do not affect the overall size of a company's balance sheet.

  • Are qualified dividends included in ordinary dividends?

    Qualified dividends are included with ordinary dividends in box 1a of the Internal Revenue Service Form 1099-DIV; the box includes all ordinary dividends earned from a particular stock. Box 1b shows the number of the dividends in box 1a that are qualified dividends. The two types of dividends are treated differently for tax purposes.

    What Are Qualified Dividends?

    Qualified dividends must be issued by U.S.-based corporations or foreign corporations that trade on major U.S. stock exchanges such as the NASDAQ and NYSE. Additionally, stocks must be held for at least 60 days within a 120-day period that begins 60 days before the ex-dividend date. Dividends that meet these criteria are taxed at the long-term capital gains rate, which ranges between 15% and 20%. Investors at the 15% income tax rate or below pay no taxes on qualified dividends. Investors at income tax rates of 25% or higher save the most money when it comes to paying taxes on qualified dividends.

    What Are Ordinary Dividends?

    Ordinary dividends are those that do not meet the above criteria. Investors pay tax on these dividends at their ordinary income tax rate. As of 2016, tax rates range from 10% to 39.6%. Investors with adjusted gross income of $200,000 — $250,000 for joint filers — also pay an additional 3.8% tax net investment income tax (NIIT) on dividend income.

    Implications for Retirement Accounts

    People who include dividend-paying stocks in their retirement investment accounts, such as 401(k)s, do not pay taxes on dividends until they begin taking distributions on the funds. People with Roth IRAs enjoy the greatest tax benefit because distributions are typically tax-free, assuming the account holder follows the rules for Roth IRA distributions.

  • Are small cap companies more risky investments than large cap companies?

    Small cap companies tend to be riskier than large cap companies. They have more growth potential, and offer better returns, especially over the long term But they do not have the resources of large cap companies, making them more vulnerable to negative events and bearish sentiments. This vulnerability is reflected in the volatility of small cap companies, which has historically been higher than that of large cap companies. They are an especially risky investment during a period of economic contraction, as they are less well-equipped than large cap companies to cope with sharply decreasing demand.

    With high volatility, the return realized by investors varies significantly from the average return they expect, making actual returns more difficult to predict and making the investment potentially more risky. For example, from 1997 through 2012, the Russell 2000 (an index of small companies) returned 8.6% on an annualized basis, compared to 4.8% for the S &P 500 (consisting mainly of large companies). Yet in the same period, the Russell 2000 had approximately one-third higher volatility.

    In the period from 2003 through 2013, the volatility of small cap funds as measured by standard deviation was 19.28. For large cap funds, it was 15.54. (Over the same period, small cap funds yielded an average annual return of 9.12%, and large cap funds yielded a return of 7.12%.) In short, this means that the return of small cap funds varied from its average by 19.28 percentage points 68% of the time, and the return of large cap funds varied from its average by 15.54 percentage points 68% of the time. The higher variability of small cap funds reflects higher volatility.

    Large cap companies are typically a safer investment, especially during a downturn in the business cycle, as they are much more likely to weather changes without significant harm. This makes them more attractive to investors, attracting a stable stream of capital, which contributes to making their volatility low.

    On the other hand, large cap companies do not have the growth potential of small cap companies, as their size prevents them from quickly changing direction and capitalizing on new opportunities; the larger resources that cushion them can also be a burden. Because they are more nimble, small cap companies can take more chances and take advantage of events and trends. This in turn leads to them historically having a better return on investment than the big guys.

  • Can a company's working capital turnover ratio be negative?

    A company's working capital turnover ratio can be negative when a company's current liabilities exceed its current assets. The working capital turnover is calculated by taking a company's net sales and dividing them by its working capital. Since net sales cannot be negative, the turnover ratio can turn negative when a company has a negative working capital.

    Working Capital

    A company maintains its working capital to finance its operations, such as purchasing inventory, collecting its accounts receivable and paying its vendors. If a company takes too much credit from its vendors or delays payments on its other obligations, such as salaries and taxes, the company's current assets may be insufficient to pay off its current liabilities. In this case, working capital turns negative, meaning that a company must raise funds immediately by either borrowing money or selling more of its products for cash to satisfy its current obligations.

    Working Capital Turnover Ratio

    The working capital turnover ratio shows the relationship between the funds used to finance a company's operations and the revenues a company generates as a result of conducting these operations. A higher working capital turnover ratio indicates that a company generates a higher dollar amount of sales for every dollar of the working capital used.

    When the working capital turns negative, so does the working capital turnover ratio. Because a company's sales cannot be negative, only negative working capital makes the working capital turnover ratio negative. A negative working capital turnover ratio is typically meaningless and cannot be compared across companies.

  • Can a stock have a negative price-to-earnings (P/E) ratio?

    Yes, a stock can have a negative price-to-earnings ratio (P/E), but it is very unlikely that you will ever see it reported. Although negative P/E ratios are mathematically possible, they generally aren't accepted in the financial community and are considered to be invalid or just not applicable. We'll explain why this is.

    The price-earnings ratio is arguably the most popular fundamental factor used by investors who try to determine the attractiveness of an asset's current value and, more importantly, whether the current price level makes for a good buying opportunity. The ratio is calculated by dividing a financial asset's current share price by its per-share earnings. Generally speaking, a low P/E value suggests that an investor needs to pay a low amount for each dollar of earnings made by the company. This could be used by investors as a sign that the given asset is undervalued and a potentially good investment at current levels. Conversely, a relatively high P/E value is used to suggest that investors will need to pay a high amount for the company's earnings, which can then be used to suggest that the asset is relatively expensive and that it may be a good idea to wait for a better entry.

    Mathematically, there are only two ways for a ratio of this form to have a negative value:

    1. The numerator falls below zero
    2. The denominator falls below zero.

    In the case of the P/E ratio, it is impossible for the numerator to fall below zero because this represents the price of the asset. However, the denominator, which is equal to the earnings of the company, can become negative. EPS values below zero mean that the company is losing money and is the reason why it is possible to have a negative P/E ratio.

    Negative EPS numbers are usually reported as "not applicable" for quarters in which a company reported a loss. Investors buying a company with a negative P/E should be aware that they are buying a share of a company that has been losing money per share of its stock.

    For further reading, see our tutorials on Understanding the P/E Ratio and Ratio Analysis.

  • Can I have more than three original Bills of Lading?

    There is no restriction on the number of bills of lading that can be issued, but the number issued must be stated on the bill. Three bills are standard – one for the shipper, one for the consignee, and one for the banker, broker or third party. For security purposes, it's advisable to only request as many bills of lading as you actually need. If more bills of lading are issued, there is an increased risk of fraud, theft, an unauthorized release or release to the wrong person.

    There are two types of bills of lading: the ocean bill of lading and the airway bill. The determining factor as to which is most applicable comes down to time. Air travel is reserved for shipments that are time-sensitive or on a tight deadline, and it is usually a bit more expensive. Travel by ocean is more economical, which is why it is more frequently utilized.

    There are many different types of ocean bills of lading, but the most common are a straight, shipper's order, clean and onboard bills of lading. The straight bill of lading is non-negotiable and must be marked as such. It can only be released to the person named on the bill.

    A shipper's order bill of lading outlines any conditions that have been imposed by the shipper. A common example is when payment has been secured by a letter of credit, and the terms must met before the delivery is accepted.

    The clean bill of lading is when everything in the shipment is in perfect order. Should any shortages of product or damages occur, a clean bill is not issued.

    An onboard bill of lading is issued when the goods are loaded onto the ship and is signed by the ship's master. This type of ocean bill of lading is rendered when payment is contingent on a letter of credit.

  • Do all countries follow the same GAAP?

    Generally accepted accounting principles, formally designated in the United States as GAAP, vary from country-to-country, and no universally accepted accounting recording and publishing system currently exists. The GAAP are a combination of procedures and standards utilized by a company when generating its financial statements. Both authoritative standards, determined by policy boards, and the most widely used and accepted means of writing and publishing accounting information are joined to create GAAP. These standards are required of companies so an investor can have some basic consistency among the financial statements of companies for comparison. Covered under the GAAP are such things as classification of items on the balance sheet, share measurements and recognition of revenue.

    The international financial reporting standards, or IFRS, are a list of principles that address the way particular transactions, procedures and various events should be indicated in a company’s financial statements. These principle-based standards are put out by the London-based International Accounting Standards Board, or IASB, and are sometimes confused with the older international accounting standards, or IAS, which were replaced by the IFRS in 2000. These standards are used by the United Kingdom and member countries of the European Union, as well as a number of other countries.

    Controversy has almost inevitably arisen when one country adopts another country’s accounting methods. Part of the reason it is so difficult to generate one set of universally accepted accounting standards is the basis on which the standards are set. The GAAP utilized in the U.S. are rules-based, while the IFRS are principles-based. The two differing fundamental approaches make it difficult to reconcile standard practices. Despite the difficulties posed, a basic, universally accepted means of documenting and publishing accounting information is sought on an ongoing basis.

  • Do banks have working capital?

    The concept of working capital does not apply to banks since financial institutions do not have typical current assets and liabilities such as inventories and accounts payable. Also, it is very hard to determine current liabilities for banks, because banks typically rely on deposits as a source for their capital, and it is not certain when a customer will demand his deposit back.

    Working Capital

    Working capital is calculated as the difference between a company's current assets and current liabilities. Working capital is used to finance a company's current operations, such as purchasing inventories, collecting accounts receivable from customers, obtaining credit from vendors, and producing and shipping products.

    Balance Sheet

    Banks do not produce physical goods; instead, they borrow and lend funds. A bank's income comes primarily from the spread between the cost of capital and interest income it earns by lending out money to the public. Also, banks do not have fixed assets, and they heavily rely on borrowing as their primary source of capital. This is especially evident from looking at a typical commercial bank's balance sheet. It has a small number of fixed assets, which primarily consist of various fixtures and buildings. Given the nature of a bank's business, its balance sheet does not contain inventories, typical accounts payable and accounts inventories, making calculating working capital an impractical endeavor.

    Another issue with calculating working capital for banks is a lack of classification of assets and liabilities by their due dates. Banks do not organize their balance sheets by current and noncurrent assets and liabilities, as it is impossible to do so. For instance, a typical bank's liabilities consist of deposits, which can be withdrawn on demand. Because it is impossible to determine with certainty when a particular deposit will be demanded, banks have no means to classify deposits as either current or noncurrent. All this makes the classification of assets and liabilities by their due dates impractical.

  • Do dividends go on the balance sheet?

    Cash dividends offer a typical way for companies to return capital to their shareholders. The cash dividend affects the cash and shareholders' equity accounts primarily. There is no separate balance sheet account for dividends after they are paid. However, after the dividend declaration and before the actual payment, the company records a liability to its shareholders in the dividend payable account.

    After the dividends are paid, the dividend payable is reversed and is no longer present on the liability side of the balance sheet. When the dividends are paid, the effect on the balance sheet is a decrease in the company's retained earnings and its cash balance. As a result, the balance sheet size is reduced. Retained earnings is listed in the shareholders' equity section of the balance sheet. 

    However, when a company reports their quarterly results, the balance sheet only reports the ending account balances. As a result, the dividend would have already been paid and the decrease in retained earnings and cash already recorded. In other words, investors won't see the liability account entries. 

    Investors can also see the total amount of dividends paid for the period in the financing section of the statement of cash flows. The cash flow statement shows how much cash is entering or leaving a company and in the case of dividends paid, it would be listed as a use of cash for the period. 


    Consider a company that has 2 million common shares and declares a cash dividend for the amount of 25 cents per share. At the time of the dividend declaration, the company records a debit to its retained earnings account for the amount of $500,000 and a credit to the dividend payable account for the same amount. After the company makes the dividend payment to its shareholders, the dividend payable account is reversed and debited for $500,000. The cash and cash equivalent account is also reduced for the same amount through a credit entry of $500,000.

    After cash dividends are paid, the company's balance sheet does not have any accounts associated with dividends. However, the company's balance sheet size is reduced, as its assets and equity are reduced by $500,000.

  • Do nonprofit organizations have working capital?

    Nonprofit organizations continuously face debate over how much money they bring in that is kept in reserve. These financial reserves are equivalent to working capital utilized by for-profit businesses in that the reserves are used to cover the organizations' liabilities and allow them to operate on a day-to-day basis.

    Nonprofit Business

    The financial fire faced by many nonprofit organizations surrounds the concept of working capital, or financial reserves, the organizations keep on hand. In general, contributors expect any resources donated to a nonprofit organization will be used to support the product or service the organization provides and not to be kept idle in an account.

    Every company or organization, however, requires funds to operate and to provide the goods or services it offers regardless of whether it is a nonprofit or for-profit organization. There are numerous nonprofit organizations that struggle to raise enough funding to support their causes, and many see keeping cash on reserve as a necessity. Still, every year, around the world, organizations suffer and fall apart because of a lack of such reserves. The survivability of these organizations depends on having sufficient operating capital to sustain operations in the face of unexpected emergencies and economic downturns.

    In the nonprofit world, working capital is commonly referred to as an "operating reserve." Generally, nonprofit boards that oversee the regulations for nonprofits specify an acceptable amount an organization can keep as unrestricted cash to maintain operations. In most cases, the board recommends the nonprofit organization keep two to four months of cash on hand to cover all operating expenses, or a certain percentage of the organization’s annual income. These figures depend entirely on the services or goods provided and the total overall income received, and may change from one year to the next. Ultimately, each nonprofit organization must set and maintain its reserve.

  • Do plane tickets get cheaper closer to the date of departure?

    The price of flights usually increases one month prior to the date of departure. Flights are usually cheapest between three and seven weeks prior to departure.

    This answer has some exceptions, notably the winter holidays. If the trip is planned during a holiday, the wisest choice is to purchase as far in advance as possible. An analysis of approximately 1.5 billion airfares conducted by CheapAir.com, purchased between one and 320 days in advance of flights, revealed that the best time to book on average is 49 days in advance. In 2014, that number was 47.

    The Volatility of Airfare Prices

    There is plenty of variability associated with the costs of flights. This variability is ultimately driven by supply and demand. However, booking later than 49 days in advance uniformly carries higher risk of an expensive ticket than booking early.

    CheapAir lays out five snippets of advice for booking flights from their analysis:

    • Prices are volatile over time. There are plenty of opportunities for great deals in the lead-up to departure. However, prices almost always spike 14 days prior to departure.

    • There are always some outliers, but airfare is on average always more expensive when it's purchased at the last minute.

    • The time between a purchase that is too early and a purchase that is too late will almost always have the best value, because prices are higher on average just as flights open and just before they close.

    • One to four months before departure is the best booking window.

    • Summer and holiday travel are exceptions to the rule.

  • Do production costs include all fixed and variable costs?

    In economics, production costs involve a number of costs that include both fixed and variable costs. Fixed costs are costs that do not change when output changes. Examples include insurance, rent, normal profit, setup costs and depreciation. Another name for fixed costs is overhead. Variable costs, also called direct costs, depend on output. A change in output causes a change in variable costs.

    For example, for a boat manufacturing company, the total fixed cost is the sum of the premises, machinery and equipment needed to make boats. This cost is not affected by the number of boats made. However, the total variable cost is dependent on the number of boats produced.

    Since total fixed costs do not change with increased output, a horizontal line is drawn on the cost curve as opposed to an upward curve drawn to show total variable costs. The upward curve of total variable costs shows the law of diminishing marginal returns. To calculate the total cost, total fixed costs are added to total variable costs.

    Average fixed cost and average variable cost can also be calculated to help analyze production cost. To calculate the average fixed cost, the total fixed cost is divided by output. An increase in production reflects a downward trend on average fixed cost, consequently reflecting a downward slope on the curve. The average variable cost is calculated by dividing total variable cost by output. The curve for average variable cost is U-shaped, because it first shows a downward fall until it reaches the minimum point before it rises again, based on the principle of proportions.

  • Does a capital expenditure (CAPEX) immediately affect income statements?

    A capital expenditure, or CAPEX, is considered an investment into the business. The money spent is not immediately reported on the income statement; rather, it is treated as an asset on the balance sheet. A CAPEX is deducted over the course of several years as a depreciation expense, beginning with the year following the purchase. The depreciation expense is reported on the income statement in the tax years it is deducted, resulting in reduced profit.

    For example, say you own a flower shop and in 2012, you purchase a delivery van for $30,000. The van is recorded as an asset on 2012's balance sheet, leaving the income statement for 2012 unaffected by the purchase. You expect to use the van for six years, so it is depreciated by $5,000 each year. So, on 2013's income statement, a $5,000 expense is then reported. While a CAPEX does not directly affect income statements in the year of purchase, for each subsequent year for the expected useful life of the asset the depreciation expense affects the income statement.

    A CAPEX may indirectly have an immediate effect on income statements depending on the type of asset that is acquired. Using the previous example, the van purchased for the flower shop is not recorded on the income statement for 2012, but gas and insurance expenses for the van are considered business expenses that affect the income statement. However, the expenses incurred by the van may be offset by the increase in revenue produced by the delivery van.

  • Does gross profit include labor and overhead?

    Gross profit is the money a company earns after subtracting the costs associated with producing and selling its products. The gross profit is represented as a whole dollar amount, showing the revenue earned after subtracting the costs of production.

    Companies calculate gross profit by subtracting the costs directly related to the production of their goods or cost of goods sold from their revenue. Gross profit measures how well a company generates profit from their labor and direct materials. 

    Components of Gross Profit

    Revenue is the total amount earned from sales for a particular period. For some industries, net sales may be used in place of revenue because net sales include deductions from returned merchandise and any discounts. Revenue is the top line on the income statement whereby costs are subtracted to achieve net income or the bottom line.

    Cost of goods sold or COGS is the direct costs associated with producing goods. COGS includes both direct labor costs, and any costs of materials used in producing or manufacturing a company's products. Some types of labor costs are included in the cost of goods sold, while others are not.

    What Are Overhead Costs?

    Overhead includes all ongoing business expenses not including or related to direct labor or direct materials used in creating a product or service. A company must pay overhead on an ongoing basis, regardless of how much or how little the company is selling. Most overhead expenses are relatively consistent from month to month, and many can be fixed. Some examples include rent and utilities.

    Manufacturing overhead or factory overhead is the overhead or indirect costs associated with manufacturing a product. For example, electricity for a factory would be included in COGS when determining the cost of producing a product. Just like direct materials costs that are part of COGS, so too must manufacturing overhead be included in the costs of goods sold and ultimately impacts gross profit.  

    Non-manufacturing overhead costs, on the other hand, are administrative costs and are not considered product costs, according to GAAP. Therefore non-manufacturing costs do not directly impact gross profit calculations. However, when pricing goods for sale, there needs to be enough markup to cover overhead costs, and so indirectly, they are captured in gross profit.

    Labor Cost

    Only direct labor involved in production is included in gross profit. As stated earlier, factory overhead including labor might be included but will be assigned a cost per product. Administrative costs such as secretaries and accountants, legal positions, janitorial workers, analysts and other non-production jobs would not have their wages included in cost of goods sold.


    Gross profit does not take into account the overall taxes paid by the company. However, it's important to note that property taxes for a manufacturing plant would be included in manufacturing overhead. In other words, a portion of the property tax on the factory would be assigned to each product when determining the cost of goods sold. The tax assigned to each product is not used in the gross profit calculation but is embedded in COGS and indirectly impacts gross profit. The overall taxes for the company that are not directly tied to production would be listed separately and deducted when calculating net income or the net profit for the company. 

    Sales Returns

    Sales returns impact revenue and cost of goods sold, ultimately affecting gross profit.

    Whenever a product is returned, and the customer is reimbursed, it gets recorded in an account called sales returns and allowances. When companies have returns, they must calculate net sales, which is revenue minus sales returns and allowances. This is why sometimes you'll see net sales listed as the top line on an income statement in place of revenue, particularly with retailers. 

    After a product is returned, the company not only has a reduction in sales but on top of that, the company subtracts the original cost of the item from the cost of goods sold account. This means that a sales return does have an impact on gross profit. 

    For more on gross profit, please read "How Do Gross Profit and Gross Margin Differ?"

  • Does the balance sheet always balance?

    Yes, a balance sheet should always balance. The name "balance sheet" is based on the fact that assets will equal liabilities and shareholer's equity every time.

    The assets on the balance sheet consist of what a company owns or will receive in the future and which are measurable. Liabilities are what a company owes, such as taxes, payables, salaries, and debt. The shareholders' equity section displays the company's retained earnings and the capital that has been contributed by shareholders. For the balance sheet to balance, total assets should equal the total of liabilities and shareholders' equity. 

    The balance between assets, liability, and equity makes sense when applied to a more straightforward example, such as buying a car for $10,000. In this case, you might use a $5,000 loan (debt), and $5,000 cash (equity) to purchase it. Your assets are worth $10,000 total, while your debt is $5,000 and equity is $5,000. In this example, assets equal debt plus equity.

    The major reason that a balance sheet balances is the accounting principle of double entry. This accounting system records all transactions in at least two different accounts, and therefore also acts as a check to make sure the entries are consistent. Building on the previous example, suppose you decided to sell your car for $10,000. In this case, your asset account will decrease by $10,000 while your cash account, or account receivable, will increase by $10,000 so that everything continues to balance. If you wish to learn more, check out Reading The Balance Sheet and Breaking Down The Balance Sheet.

    The three sections of the balance sheet are:


    Current assets represent the value of all assets that can reasonably expect to be converted into cash within one year and are used to fund ongoing operations and pay current expenses. Some examples of current assets include 

    • Cash and cash equivalents
    • Accounts receivable,
    • Prepaid expenses, 
    • Inventory,
    • Marketable securities.

    Noncurrent assets are a company’s long-term investments or any asset not classified as current. Both fixed assets, like plant and equipment, and intangible assets, like trademarks fall under noncurrent assets. Some examples of noncurrent assets are:

    • Land,
    • Property, plant, and equipment,
    • Trademarks,
    • Long-term investments and even goodwill.


    Current liabilities are short-term liabilities that are due within one year and include: 

    • Accounts payable are short-term debt owed to suppliers.  
    • Accrued expenses are expenses that have yet to be paid, but have a high probability of being paid.

    Noncurrent liabilities are also listed on the balance sheet and are included in the calculation of a company's total liabilities. Noncurrent liabilities are long-term debts or obligations and unlike current liabilities, a company does not expect to repay its non-current liabilities within a year. Some examples of noncurrent liabilities include:

    • Long-term lease obligations,
    • Long-term debt like bonds payable.

    For example, a company's long-term lease that lasts more than one fiscal year is listed on the balance sheet. The rental arrangement is listed as an asset on the balance sheet, and the lease obligation is listed as a liability. Since the lease lasts longer than one fiscal year, it is a noncurrent liability.

    Shareholders' Equity

    • Retained earnings is money held by a company to either reinvest in the business or pay down debt. Retained earnings is also earnings that hasn't been paid to shareholders via dividends. 
    • Shareholders' equity is the net of a company's total assets and its total liabilities. Shareholders' equity represents the net worth of a company and helps to determine its financial health. Shareholders' equity is the amount of money that would be left over if the company paid off all liabilities such as debt in the event of liquidation. 

    Below is an example of a balance sheet to illustrate how it balances out. 

    Apple Inc. (AAPL)

    Below is Apple's balance sheet, as of the end of their fiscal year for 2017, from their annual 10K statement. We can see how the balance sheet balances by the following:

    • Total assets were $375 billion.
    • Total liabilities were $241 billion.
    • Shareholders' equity was $134 billion (highlighted in yellow). 

    At the bottom of the balance sheet, we can see that total liabilities and shareholders' equity are added together to come up with $375 billion which balances with Apple's total assets.

    If the balance sheet you're working on does not balance, it's an indication that there's a problem with one or more of the accounting entries. 

    For more on financial statements, please read How The Income Statement And Balance Sheet Differ? 

  • Does U.S. GAAP prefer FIFO or LIFO accounting?

    Unlike the inventory reporting rules under the International Financial Reporting Standards, or IFRS, the generally accepted accounting principles, or GAAP, do not require companies to use the first-in first-out, or FIFO, method exclusively. American companies are allowed to decide between FIFO or last-in first-out, otherwise known as LIFO, cost accounting.

    Under President Obama, the federal government has lobbied to repeal the LIFO standard in the United States. If that takes place, it would be easier for the country to convert to the IFRS system. American companies that have decided to use LIFO must also provide FIFO figures in their financial statement footnotes.


    LIFO and FIFO are the two most commonly used inventory accounting methods in the U.S. Switching between methods can affect company valuation, financial statements and tax filing. FIFO is the preferred method outside of the U.S., and there is strong pressure from progressive accounting authorities on the Financial Accounting Standards Board, or FASB, to adopt IFRS standards.

    Under the FIFO system, the first unit of a piece of inventory is assumed to be the first to come off of the shelves. Consider a company that makes toy cars. Input costs are not fixed over time, so the first 100 toy cars may cost $10 to make while the last 100 might cost $12. According to the FIFO method, the cost of goods sold, or COGS, for the first sales is $10.

    Under a LIFO system, the first sales are associated with a $12 COGS. This has a significant impact on ending inventory on the balance sheet. The reason the LIFO system is controversial is that the last items in inventory tend to age and could potentially become obsolete.

    Under GAAP, companies have a choice as to which inventory valuation system is the most advantageous for reporting purposes. This is not the case with the IFRS method, where all companies are locked into FIFO.

  • Does unearned revenue affect working capital?

    Unearned revenue, or deferred revenue, typically represents a company's current liability and affects its working capital by decreasing it. Unearned revenue is recorded when a firm receives a cash advance from its customer in exchange for products and services that are to be provided in the future. Because a company cannot recognize revenue on this cash advance and it owes money to a customer, it must record a current liability for any portion of the cash advance for which it expects to provide services within a year. Since current liabilities are part of the working capital, a current balance of unearned revenue reduces a company's working capital.

    Unearned Revenue

    Unearned revenue typically arises when a company receives compensation and it still has to provide products for which the payment was made. Consider a media company that asks its customers to pay $120 in advance for annual subscriptions to its monthly magazine. When a customer sends a $100 payment, the media company records a $100 debit to its cash balance and a $100 credit to its unearned revenue account. When the company ships magazines to a customer once a month, it can decrease its unearned revenue by $10 by recording a debit to the unearned revenue account and a $10 credit to its revenue account.

    Working Capital

    Working capital is the difference between a company's current assets and its current liabilities, which it records on its balance sheet. If a company has a balance of earned revenue for services it intends to provide within a year, this balance is considered a current liability and would decrease the working capital.

  • Does working capital include inventory?

    A company's working capital includes inventory, and increases in inventory make working capital increase. Working capital is calculated as the difference between a company's current assets and current liabilities. Inventory is classified as part of the current assets since there is an expectation that this asset is going to be consumed and produce economic benefits within a year.


    Inventory represents products a company owns and plans to use in its production process within the next year. Inventory can be in the form of raw materials, work in progress or finished goods. Raw materials can include commodities such as metal or oil, while work-in-progress inventory refers to goods that have undergone a certain level of processing on a company's production line but are not finished goods yet. Finished goods are products that are available for sale by a company. Certain companies such as clothing retailers do not have raw materials or work in progress included in their inventories due to the nature of their business.

    Keeping inventory on hand is not only costly, as a company has to incur warehousing expenses, but it also presents an opportunity cost as the company could have done other profitable things with the funds invested in inventory. Also, inventory tends to become obsolete or even spoil, resulting in balance sheet declines and charges on a company's income statement.

    Working Capital and Inventory

    Inventory is an integral part of a typical company's current assets and working capital. For certain types of companies, such as general retail and grocery, inventory can represent a substantial part of the current assets with over a 70% share. For companies in the manufacturing industry, inventory may claim less than 10% of the current assets. Working capital can fluctuate significantly from year to year if a company underestimates or overestimates demand for its products. Also, many companies shift to just-in-time (JIT) inventory management, resulting in a smaller inventory share in a company's working capital.

  • Does working capital include salaries?

    A company accrues unpaid salaries on its balance sheet as part of accounts payable, which is a current liability account, so they count towards the calculation of the company's working capital. However, the company would not record paid salaries as current liabilities, so they would not affect the calculation of working capital.

    Unpaid Salaries

    Unpaid salaries represent a company's arrears to its workers for a specific period of time. A company typically expenses unpaid salaries immediately through a debit entry to its income statement. Since the company has not yet paid those salaries, it has a liability to its workers and must accrue them by recording an equivalent credit entry to its accrued salaries account, which is a current liability account on the company's balance sheet.

    Unpaid salaries typically arise as a result of a timing difference between closing the company's books and when the actual payroll payment to its workers goes out of the cash account. Since current liabilities are part of the working capital calculation, unpaid salaries decrease the company's working capital.

    Once an unpaid salary is cleared through a payment to the workers, accountants record a credit entry to the cash and cash equivalents account and a debit entry to the accrued salaries account. If a company has paid all salaries, it does not owe money to its workers and its balance sheet does not contain a current liability account. Therefore, salaries do not affect the working capital for a company that has paid all its wages.

  • Free & operating cash flows: What's the Difference?

    The calculation used to determine free cash flow is net income plus amortization and depreciation minus change in working capital minus capital expenditures. Operating cash flow is calculated in the same way, omitting capital expenditures.

    Free cash flow is most commonly defined as operating cash flow minus capital expenditures. A more stringent definition includes dividend outlays as a capital expenditure. Capital expenditures are considered necessary to maintain a company's competitive position and operating efficiency. Many analysts feel dividend outlays are just as important an expense as capital expenditures. The board of directors of a company may elect to reduce a dividend payment. However, this usually has a negative effect on stock price as investors tend to sell holdings in companies that reduce dividends.

    Free cash flow and operating cash flow are sometimes used to define a ratio that is useful when comparing competitors in the same or comparable industries.

    Free cash flow is a measure of financial performance, similar to earnings, and its use is considered one of the non-Generally Accepted Accounting Principles. It measures the cash flow available for distribution to all company securities holders. It can be envisioned as cash left after the financing of projects to maintain or expand the asset base. Many analysts prefer free cash flow to earnings as a basis for evaluating a company's performance because free cash flow is more difficult to fabricate. In general terms, the higher a firm's free cash flow, the better.

    Operating cash flow, free cash flow and earnings are all important metrics in the evaluation of a company being considered for investment. Booking a large sale has the effect of boosting earnings. However, if a company is not paid for that sale, cash flow is affected. In other situations a company may be very profitable on a cash-flow basis, but have meager earnings if it is in capital intensive industries, which require large fixed asset outlays. Accelerated depreciation of assets also creates a widened differential between cash flow and earnings reported.

    Apple (AAPL) reported free cash flow of $70.02 billion in 2015, up 39.64% from the previous year. Apple reported operating cash flow of $81.27 billion, up 36.09% from 2014. Net income was reported to be $53.39 billion, representing an increase of 35.14%. On an annual basis, Apple has increased its both its operating and free cash flow in each of the past five years. Earnings saw a decrease from 2012 to 2013 and have risen in each other of the past five years before the report. 

    Companies with higher operating cash flow, free cash flow and earnings tend to have higher appreciation in the value of their shares. Some analysts also study free cash flow, operating cash flow and earnings on a per share basis. This allows for dilution of cash flow or earnings if a company issues more shares to raise capital and through employee compensation packages.

  • Have hedge funds eroded market opportunities?

    Hedge funds have not eroded market opportunities for longer-term investors. Many investors incorrectly assume they cannot compete with hedge funds in the marketplace and that the odds are stacked against them. There are some strategies such as high-frequency trading that investors cannot compete with; still, even though hedge funds have grown in their influence on the market, there are still opportunities for investors seeking to grow their wealth for the future.

    Growth of Hedge Funds

    The number of hedge funds has grown substantially since 2000. There were slightly over 2,000 hedge funds in operation in 2000. That number grew to over 10,000 funds by 2014. The amount of assets under management (AUM) for hedge funds has also grown from around $500 billion in 2000 to over $2 trillion in 2014. Most hedge funds seek to create alpha for their investors in different types of market conditions. Not all hedge funds are successful; in fact, many fail to provide better performances than simple market index funds. This indicates there is still money to be made in the markets for ordinary investors.

    Value Investing

    One significant opportunity for investors is value investing as championed by investing guru Warren Buffett. Value investing is a long-term investment strategy that seeks to identify undervalued companies with the potential for growth. Value investors buy companies that have fallen out of favor with the market for whatever reason and are trading below their intrinsic values.

    Value investing requires capital, education, research and some time to follow the markets. However, since investments are made on a long-term basis, there are limited trading costs. Value investing does not try to identify short-term trades and is not constantly jumping in and out of the market. This makes the strategy available to individual investors.

    Index Investing

    Another strategy available to investors is index investing. Index investing uses index funds to track the major stock indexes such as the S&P 500, the Dow Jones Industrial Composite and the NASDAQ. History shows stock indexes generally go up over time. However, there are definitely substantial drawdowns such as during the 2008 financial crisis. Still, the equity markets have generally grown. In fact, Warren Buffett recommends most investors invest in a low-cost index fund. These index funds provide diversified exposure to companies in many different sectors.

    Fixed-Income Investing

    A more conservative strategy for individual investors is fixed-income investing. Fixed-income investors buy bonds and other fixed-income securities to profit from the payment of interest. Bonds generally have less volatility than stocks and other asset classes. There are numerous types of fixed-income securities in which to invest.

    There is still risk in investing in bonds such as interest rate risk and credit downgrade risk. Further, fixed-income securities have paid minimal interest in the low-interest-rate environment since the 2008 financial crisis. However, for more conservative investors, fixed-income securities provide the opportunity to create a stream of income from interest payments.

  • How Are Book Value and Market Value Different?

    Although investors have many metrics for determining the valuation of a company's stock, two of the most commonly used are book value and market value. Both valuations can be helpful in calculating whether a stock is fairly valued, overvalued or undervalued. In this article, we'll delve into the differences between the two and how they are used by investors and analysts. 

    Book Value

    The book value of a stock is theoretically the amount of money that would be paid to shareholders if the company was liquidated and paid off all of its liabilities. As a result, the book value equals the difference between a company's total assets and total liabilities. Book value is also recorded as shareholders' equity. In other words, the book value is literally the value of the company according to its books (balance sheet) once all liabilities are subtracted from assets. 

    The need for book value also arises when it comes to generally accepted accounting principles (GAAP). According to these rules, hard assets (like buildings and equipment) listed on a company's balance sheet can only be stated according to book value. This sometimes creates problems for companies with assets that have greatly appreciated - these assets cannot be re-priced and added to the overall value of the company.

    Calculating The Book Value Of Bank of America Corporation (BAC)

    Below is the balance sheet for the fiscal year ending for 2017 according to the bank's annual 10K statement.

    • Assets totaled $2,281,234 trillion.
    • Liabilities totaled $2,014,088 trillion. 
    • The book value was $267,146 billion as of the end of 2017.

    In theory, if Bank of America liquidated all of its assets and paid down its liabilities, the bank would have roughly $267 billion left over to pay shareholders. 

    Market Value 

    The market value is the value of a company according to the financial markets. The market value of a company is calculated by multiplying the current stock price by the number of outstanding shares that are trading in the market. Market value is also known as market capitalization.  

    For example, Bank of America had over 10 billion shares outstanding (10,207,302,000) as of the end of 2017 while the stock traded at $29.52 making BofA's market value or market capitalization at 301 billion (10,207,302,000 * 29.52).

    How Book Value & Market Value Are Interpreted

    When the market value of a company is less than its book value, it may mean that investors have lost confidence in the company. In other words, the market may not believe the company is worth the value on its books or that there are enough future earnings. Value investors might look for a company where the market value is less than its book value hoping that the market is wrong in its valuation.

    For example, during the Great Recession, Bank of America's market value was below its book value. Now that the bank and the economy have recovered, the company's market value is no longer trading at a discount to its book value.  

    When the market value is greater than the book value, the stock market is assigning a higher value to the company due to the earnings power of the company's assets. Consistently profitable companies typically have market values greater than their book values because investors have confidence in the companies' ability to generate revenue growth and ultimately earnings growth. 

    When nook value equals market value, the market sees no compelling reason to believe the company's assets are better or worse than what is stated on the balance sheet.

    The Bottom Line

    Book value and market value are two fundamentally different calculations that tell a story about a company's overall financial strength. Comparing the book value to the market value of a company can also help investors determine whether a stock is overvalued or undervalued given its assets, liabilities and its ability to generate income. However, with any financial metric, it's important to recognize the limitations of book value and market value and use a combination of financial metrics when analyzing a company.

    For more on this topic including examples, please read Market Value Versus Book Value and Using the Price-to-Book Ratio to Evaluate Companies.

  • How are cash purchases recorded on a company's income statement?

    Cash purchases are recorded more directly in the cash flow statement than in the income statement. In fact, specific cash outflow events do not appear on the income statement at all. Rather, different items on the operating section of a company's income statement are affected by the balance of cash purchases, credit purchases and other previously recorded transactions. One of the limiting features of the income statement is it does not show when revenue is collected or when expenses are paid.

    Any investor who wants to look at cash purchases should instead look at the cash flow statement. The cash flow statement further differentiates between cash purchases for financing activities, investing activities and operating activities. For really detailed entries, cash payments are listed in the general ledger by crediting the cash account and debiting the corresponding payable.

    Role of the Income Statement

    In financial accounting, the income statement is designed to show summaries of financial activity on a quarterly or annual basis. These summaries are drawn from the general ledger. There may be footnotes in an income statement that describe specific cash purchases, but this is not a reliable source for specific line item details.

    Operating Section of the Income Statement

    With larger, exchange-listed companies, cash flows are most likely built into the revenue and expenses portion of the operating section. Any cash purchases made in the course of normal operations increases the recorded expenses of the company.

    Depending on the company in question, the expenses portion may be broken down into more specific sub-categories. Even in these cases, specific cash purchases are not recorded. The aggregate of all cash purchases and other cash outflows is instead built into the figures listed in the expenses portion.

  • How are contingent liabilities reflected on a balance sheet

    Contingent liabilities need to pass two thresholds before they can be reported in the financial statements. First, it must be possible to estimate the value of the contingent liability. If the value can be estimated, the liability must have a greater than 50% chance of being realized. Qualifying contingent liabilities are recorded as an expense on the income statement and a liability on the balance sheet.

    If the contingent loss is remote, meaning it has a less than 50% chance of occurring, the liability should not be reflected on the balance sheet. Any contingent liabilities that are questionable before their value can be determined should be disclosed in the footnotes to the financial statements.

    Examples of Contingent Liabilities

    Two classic examples of contingent liabilities include a company warranty and a lawsuit against the company. Both represent possible losses to the company, yet both depend on some uncertain future event.

    Suppose a lawsuit is filed against a company, and the plaintiff claims damages up to $250,000. It's impossible to know whether the company should report a contingent liability of $250,000 based solely on this information.

    Here, the company should rely on precedent and legal counsel to ascertain the likelihood of damages. If a court is likely to rule in favor of the plaintiff, whether because there is strong evidence of wrongdoing or some other factor, the company should report a contingent liability equal to probable damages. This is true even if the company has liability insurance.

    If the lawsuit is frivolous, there may be no need for disclosure. Any case with an ambiguous chance of success should be noted in the financial statements but need not be listed as a liability on the balance sheet.

    GAAP Guidelines

    Companies operating in the United States rely on the guidelines established in the generally accepted accounting principles (GAAP). Under GAAP, a contingent liability is defined as any potential future loss that depends on a "triggering event" to turn into an actual expense.

    It's important that shareholders and lenders have warning about possible losses; an otherwise sound investment might look foolish after an undisclosed contingent liability is realized.

    There are three GAAP-specified categories of contingent liabilities: probable, possible and remote. Probable contingencies are likely to occur and can be reasonably estimated. Possible contingencies do not have a more-likely-than-not chance of being realized, but are not necessarily considered unlikely either. Remote contingencies aren't likely to occur and aren't reasonably possible.

    Working through the vagaries of contingent accounting is sometimes challenging and inexact. Company management should consult experts or research prior accounting cases before making determinations. In the event of an audit, the company must be able to explain and defend its contingent accounting decisions.

    Any probable contingency needs to be reflected in the financial statements -- no exceptions. Remote contingencies should never be included. Contingencies that are neither probable or remote should be disclosed in the footnotes of the financial statements.

  • How are cost of goods sold and cost of sales different?

    Fundamentally, there is almost no difference between a company's listed cost of goods sold (COGS) and cost of sales. The two terms are typically used interchangeably in an accounting context.

    Cost of sales, also known as the cost of revenue, and cost of goods sold (COGS) both keep track of how much it costs a business to produce a good or service to be sold to customers. Both cost of sales and COGS include the direct costs associated with the production of a company's goods and services. These costs include direct labor, direct materials, such as raw materials, and the overhead that's directly tied to the production facility or manufacturing plant. 

    The cost of sales and COGS are key metrics in cost analysis since they show the operational costs of the production of goods and services. If cost of sales is rising while revenue has stagnated, it might be an indication that input costs have increased or other direct costs are not being appropriately managed. Cost of sales and COGS are subtracted from total revenue to yield gross profit.

    Retailers typically use cost of sales, whereas manufacturers use cost of goods sold. Since service-only businesses cannot directly tie any operating expenses to something tangible, they cannot list any cost of goods sold on their income statements. Instead, service-only companies typically show cost of sales or cost of revenue. Businesses that might have no cost of goods sold include attorneys, painters, business consultants, and doctors. 

    Some service providers offer secondary products to their customers; for example, airlines offer food and beverages, and some hotels sell souvenirs. The costs associated with these items can also be listed as cost of goods sold. Companies that offer both services and goods are likely to have both cost of goods sold, and cost of sales appear on their income statements.

  • How are current and noncurrent assets different?

    Assets can be divided into two categories: current and noncurrent. Current assets are items listed on a company's balance sheet that are expected to be converted into cash within one fiscal year. Conversely, noncurrent assets are long-term assets that a company expects to hold over one fiscal year and cannot readily be converted into cash. Current and noncurrent assets are located on the balance sheet. 

    Current Assets

    Current assets represent the value of all assets that can be converted to cash and are used to fund the ongoing operations of the company and pay current expenses.

    Current assets include:

    • Cash and cash equivalents
    • Accounts receivable
    • Prepaid expenses
    • Inventory
    • Marketable securities

    Cash is considered a current asset because it can be readily converted within one year and can be used to pay short-term debt. Accounts receivable consist of the expected payments from customers to be collected within one year. Inventory is also a current asset because it includes raw materials and finished goods that can be sold relatively quickly.

    Noncurrent Assets

    Noncurrent assets are a company’s long-term investments or long-term assets that have a useful life of more than one year. Noncurrent assets cannot be easily converted to cash.

    Non-current assets include:

    • Land
    • Property, plant, and equipment
    • Trademarks
    • Long-term investments and goodwill

    Both fixed assets and intangible assets, fall under noncurrent assets.

    Fixed assets include property, plant, and equipment since they are tangible, meaning they are physical in nature or can be touched. A company cannot easily liquidate property, plant, and equipment. For example, an auto manufacturer's production facility would be a noncurrent asset.

    Intangible assets are nonphysical assets, such as patents and copyrights. They are considered to be noncurrent assets because they provide value to a company but cannot be readily converted to cash within a year. Long-term investments, such as bonds and notes, are also considered noncurrent assets because a company usually holds these assets on its balance sheet for more than one fiscal year.

    Below is a portion of Exxon Mobil Corporation's (XOM) balance sheet as of the end of March 31, 2018. 

    • Current assets sit at the top of the balance sheet, highlighted in green, and include receivables due to Exxon, cash, and inventory.
    • Noncurrent assets are below current assets, highlighted in blue, representing Exxon's long-term investments like oil rigs and production facilities listed under property, plant, and equipment.
    • Current liabilities are colored in orange and include short-term debt owed by Exxon and taxes.
    • Noncurrent liabilities are listed below and include long-term debt obligations.

    For more on how to analyze a balance sheet, please read "How Do the Income Statement and Balance Sheet Differ?"

  • How are EBIT and operating income different?

    EBIT (earnings before interest and taxes) is a company's net income before interest expense, and income tax expense have been deducted. EBIT is often considered synonymous with operating income, although there are exceptions. Investors and creditors use EBIT to analyze the performance of a company's core operations without tax expenses and capital structure costs distorting the profit figures. EBIT is calculated by the following formula: 

    EBIT = Net income + Interest expense + Tax expense

    Since net income includes the deductions of interest expense and tax expense, they need to be added back into net income to calculate EBIT. 

    Operating income is a company's profit after subtracting operating expenses and the costs of running the business from total revenue. Operating income shows how much profit a company generates from its operations alone without interest or tax expenses. Operating income is calculated as gross income minus operating expenses. Operating expenses include selling, general and administrative expense (SG&A), depreciation, and amortization, and other operating expenses.

    Operating income excludes taxes and interest expenses, which is why it's often referred to as EBIT. However, there are times when operating income can differ from EBIT.

    Comparing EBIT and Operating Income

    Below is a portion of the income statement for Macy's Inc. (M) as of May 5, 2018.

    • Operating income was $238 million, highlighted in blue.
    • Net income was $131 million, highlighted in green.
    • Interest expense was $71 million while tax expense was $52 million, highlighted in red.
    • EBIT was $254 million for the period or $131 million (net income) + $52 million (taxes) + $71 million (interest).

    We can see in the above example that operating income of $238 million was different from EBIT of $254 million for the quarter. The reason for the difference is that operating income does not include non-operating income, non-operating expenses, or other income, but those numbers are included in net income. The difference in the two numbers highlights the importance of not assuming that operating income will always equal EBIT.

    In the case of Macy's, we can see there was a benefit plan credit of $11 million and interest income of $5 million totaling $16 million and gives us the difference between operating income and EBIT calculations.  

    EBIT and operating income are both important metrics in analyzing the financial performance of a company. Our example shows the importance of using multiple metrics in analyzing the profitability of a company. For example, a company may have interest income as a key driver of revenue such as credit financing whereby EBIT would capture the interest income while operating income would not.

    For more of analyzing profits, please read "How Are Gross Profit and EBITDA Different?"

  • How are EBITDA, EBITDAR, and EBITDARM different?

    There are many financial metrics available to analyze the profitability of a company. Each metric typically includes or excludes particular line items to arrive at its result. EBITDA, EBITDAR, and EBITDARM are profitability indicators to help evaluate the financial performance and resource allocation for operating units within a company.

    Understanding EBITDA

    EBITDA (earnings before interest, taxes, depreciation and amortization) measures a company's profitability. EBITDA removes the costs of debt financing, tax expense, as well as depreciation, and amortization expenses from profits. As a result, EBITDA can be beneficial since it provides a stripped-down view of a company's profitability from its core operations.  

    EBITDA is calculated by taking operating income and adding back depreciation and amortization. EBITDA became popular in the 1980's to show the potential profitability of leveraged buyouts. However, at times, it has been used by companies that wish to disclose more favorable numbers to the public.

    Understanding EBITDAR

    EBITDAR (earnings before interest, taxes, depreciation, amortization and rent/restructuring costs) is a variation of EBITDA whereby rent and restructuring costs are excluded. EBITDAR is useful for companies undertaking restructuring efforts since restructuring charges are typically one-time or non-recurring expenses. Removing the restructuring costs shows a clearer picture of the operating performance of the company and perhaps might help with obtaining financing from a creditor.

    Understanding EBITDARM

    EBITDARM (earnings before interest, taxes, depreciation, amortization, rent/restructuring costs and management fees) strips out rental costs as well as management fees.

    EBITDARM is helpful when analyzing companies where the rent and management fees make up a substantial amount of operating costs. Hospitals, for example, typically lease the building space that they use, meaning rental fees can be a major operating cost. Also, companies that require a large amount of storage space will also have high rental expenses, and EBITDARM can help to strip out those costs allowing a better view of the operational performance of those companies.

    For more on this topic, please read "A Clear Look at EBITDA" and "How Are Operating Income and EBITDA Different?"

  • How are fixed costs treated in cost accounting?

    Fixed costs are one of the two major inputs, along with variable costs, in cost accounting that are used by a company's management team to determine budgets and control expenses in relation to revenues.

    Cost Accounting

    Cost accounting is a business tool that management uses to evaluate production costs, prepare budgets and take appropriate cost control measures to improve the company's profit margins. The purpose of cost accounting is to determine a company's production costs by examining direct and indirect costs involved in manufacturing the company's products.

    Fixed Costs

    Fixed costs are one element examined in the process of cost accounting. Fixed costs are those costs that are independent of changes in production output or revenues. These are costs that remain relatively the same regardless of whether a company manufactures 10 widgets or 10,000 widgets in a given month. Fixed costs are associated with the basic operating and overhead costs of a business. They include items such as building rent, utilities, wages and insurance. Most forms of depreciation and tangible assets qualify as fixed costs as well.

    Fixed costs are considered indirect costs of production. They are not costs incurred directly by the production process, such as parts needed for assembly, but they nonetheless factor into total production costs; for there to be production, the business has to be functioning and operational, and fixed costs represent those necessary operating costs.

    "Fixed" in this context does not mean completely unchangeable, only that the costs do not generally change based on production levels or revenue. However, fixed costs change somewhat over time as a company makes changes or expands and consequently hires additional personnel or acquires new facilities.

    Fixed Vs. Variable Costs

    The other major cost component that companies consider in cost accounting is variable costs. Variable costs are the direct production costs that, unlike fixed costs, do vary according to levels of production or sales. Variable costs are commonly designated as cost of goods sold (COGS), whereas fixed costs are expenses not usually included in COGS. Fluctuations in sales and production levels can affect variable costs if factors such as sales commissions are included in per unit production costs.

    Fixed costs plus variable costs make up the total ongoing expenses for a company that are examined in cost accounting for management to analyze expenses in relation to revenues, with the goal of improving cost efficiency and profit margins.

    Some companies choose to classify some costs as mixed, a combination of fixed and variable costs. An example might be a company's electric bill, a part of which is fixed, but a part of which varies in accordance with production; more electricity is being used when the production machinery is running.

  • How are gross profit and EBITDA different?

    Gross profit and EBITDA (earnings before interest, taxes, depreciation and amortization) show the earnings of a company. However, the two metrics calculate profit in different ways.

    Gross Profit

    Gross profit is the income earned by a company after deducting the direct costs of producing its products.

    Gross profit measures how well a company generates profit from their direct labor and direct materials. Gross profit does not include non-production costs such as costs for the corporate office. Only the revenue and costs of the production facility are included in gross profit.

    When analyzing an income statement, gross profit is calculated by the following:

    Gross profit = Revenue - Cost of Goods Sold

    Revenue is the total amount of income earned from sales in a period. Revenue is also be called net sales because discounts and deductions from returned merchandise may have been deducted. Revenue is considered the top line earnings number for a company since it's located at the top of the income statement.

    Cost of goods sold or COGS is the direct costs associated with producing goods. Some of the costs included in gross profit include:

    • Direct materials
    • Direct labor
    • Equipment costs involved in production
    • Utilities for the production facility

    Example of Gross Profit 

    Below is a portion of the income statement for JC Penney Company Inc. (JCP) as of May 5, 2018.

    • Total revenue was $2.67 billion, highlighted in green.
    • COGS is below revenue coming in at $1.7 billion.
    • Gross profit was $970 million for the period.

    As we can see from the example, gross profit does not include operating expenses such as overhead. Gross profit also doesn't include, interest, taxes, depreciation, and amortization. As a result, gross profit is effective if an investor wants to analyze the financial performance of revenue from production, and management's ability to manage the costs involved in production. However, if the goal is to analyze operating performance while including operating expenses, EBITDA is a better financial metric.


    EBITDA is one indicator of a company's financial performance and is used as a proxy for the earning potential of a business. EBITDA strips out the cost of debt capital and its tax effects by adding back interest and taxes to earnings. EBITDA also removes depreciation and amortization, a non-cash expense, from earnings. Also, EBITDA helps to show the operating performance of a company before taking into account the capital structure such as debt financing. 

    EBITDA can be used to analyze and compare profitability among companies and industries as it eliminates the effects of financing and accounting decisions. EBITDA can be calculated by the following formula:

    EBITDA = Operating Income + Depreciation and Amortization

    Operating income is a company's profit after subtracting operating expenses or the costs of running the daily business. Operating income helps investors separate out the earnings for the company's operating performance by excluding interest and taxes.

    Example of EBITDA

    Below is the same income statement from our gross profit example for JC Penney Company Inc. (JCP) as of May 5, 2018.

    • Operating income was $3 million, highlighted in blue.
    • Depreciation was $141 million, but the $3 million in operating income includes subtracting the $141 million in depreciation. As a result, depreciation and amortization need to be added back into the operating income number during the EBITDA calculation.
    • EBITDA was $144 million for the period or $141 million + $3 million.
    • We can see that interest expenses and taxes are not included in operating income, highlighted in green, but instead, are included in net income or the bottom line.

    The above example shows that the EBITDA figure of $144 million was quite different from the $970 million gross profit figure during the same period. One metric is not better than the other. Instead, they both show the profit of the company in different ways by stripping out different items. Operating expenses are removed with gross profit. Non-cash items like depreciation, as well as taxes and the capital structure or financing, are stripped out with EBITDA.


    Investors and analysts might want to break down the different profit metrics to peer into the workings of a company. EBITDA helps to strip out management decisions or possible manipulation by removing debt financing for example, while gross profit can help analyze the production efficiency of a retailer that might have a lot of cost of goods sold as in the case of JC Penney.

    Since depreciation is not captured in EBITDA, it has some drawbacks when analyzing a company with a significant amount of fixed assets. For example, an oil company might have large investments in property, plant, and equipment. As a result, the depreciation expense would be quite large, and with depreciation expenses removed, the earnings of the company would be inflated.

    EBITDA can also be calculated by taking net income and adding back interest, taxes, depreciation, and amortization. Please bear in mind that each EBITDA formula can result in different profit numbers. The difference between the two EBITDA calculations may be explained by the sale of a large piece of equipment or investment profits, but if that inclusion is not specified explicitly, this figure can be misleading. As a result, both EBITDA formulas might yield slightly different results, and investors should be aware of what components make up the difference. 

    For more on analyzing the profitability of a company, please read "How Do Gross Profit and Gross Margin Differ?"

  • How are leveraged buyouts financed?

    A leveraged buyout (LBO) is a transaction in which the buyer borrows a significant portion of the requisite funds to purchase the specified asset from the seller. LBOs are often executed by private equity groups. When the existing ownership of a business is looking to exit, it often finds willing buyers among private equity firms.

    In addition to the equity provided by the private equity sponsor, buyers often use borrowed funds to comprise the total purchase price when executing a buyout. A key feature of an LBO is that the borrowing takes place at the company level, not with the equity sponsor. The company that is being bought out by a private equity sponsor essentially borrows money to pay out the former owner.

    Bank Financing

    A private equity sponsor often uses borrowed funds from a bank or from a group of banks called a syndicate. The bank structures the debt (revolving, term debt or both) in various tranches and lends money to the company for working capital and to pay out the exiting ownership.

    Bonds or Private Placements

    Bonds and private notes can be a source of financing for an LBO. A bank or bond dealer acts as an arranger in the bond market on behalf of the company being sold, assisting the company in raising the debt on the public bond market.

    Mezzanine, Junior or Subordinated Debt

    Subordinated debt (also called mezzanine debt or junior debt) is a common method for borrowing during an LBO. It often takes place in conjunction with senior debt (bank financing or bonds as described above) and has features that are both equity-like and debt-like.

    Seller Financing

    Seller financing is another means of financing an LBO. The exiting ownership essentially lends money to the company being sold. The seller takes a delayed payment (or series of payments), creating a debt-like obligation for the company, which, in turn provides financing for the buyout.

  • How are mezzanine loans structured?

    Mezzanine loans are a combination of debt and equity finance, most commonly utilized in the expansion of established companies rather than as start-up or early-phase financing. This type of financing is similar to debt capital in that it provides the lending party the right to adjust terms to access an ownership or equity interest in the company if the loan is not paid back fully and on a timely basis. These types of loans are made available in short periods of time and usually only require minimal collateral from the borrower. Mezzanine loans command significantly higher interest rates, typically within the range of 20% to 30%.

    Mezzanine financing is the part of a company's capital that exists between senior debt and common equity as either subordinated debt, preferred equity or a combination of the two. A number of characteristics are common in the structuring of mezzanine loans, such as:

    • In relation to the priority with which they are paid, these loans are subordinate to senior debt but senior to common equity.

    • Differing from standard bank loans, mezzanine loans demand a higher yield than senior debt and are often unsecured.

    • No principal amortization exists.

    • Part of the return on a mezzanine loan is fixed, which makes this type of security less dilutive than common equity.

    • Subordinated debt is made up of a current interest coupon, payment in kind and warrants.

    • Preferred equity is junior to subordinated debt, causing it to be viewed as equity coming from more senior members in the structure of the capital financing.

    Companies commonly seek mezzanine financing to support specific growth projects or acquisitions. The benefits for a company in obtaining mezzanine financing include the fact that the providers of mezzanine capital are often long-term investors in the company. This makes it easier to obtain other types of financing, since traditional creditors generally view a company with long-term investors in a more favorable light and are therefore more likely to extend credit and favorable terms to that company.

    Mezzanine loans assist in generating more capital for a business in addition to allowing it to increase its returns on equity and show a higher bottom-line profit. Mezzanine loans typically do not require payment during the term of debt, only at the end of the term. This enables a company to improve its cash flow. The company can also use the additional available funds to pay off other existing debt, invest working capital, develop products or finance market expansion. The company may also wish to hold onto the additional cash and allow it to accumulate on its balance sheet while seeking potential future opportunities to put the funds to their best possible use.

  • How are Net Credit Purchases calculated in the accounts payable turnover ratio?

    The accounts payable turnover ratio treats net credit purchases as equal to cost of goods sold (COGS) plus ending inventory, less beginning inventory. This figure, otherwise called total purchases, serves as the numerator in the accounts payable turnover ratio.

    Most general purpose financial statements do not include total net purchases as a figure, but its components can be found separately in the statements.

    Net Credit Purchases

    The specific calculation for net credit purchases, sometimes referred to as total net payables, might vary from company to company. Much also depends on the nature of the business; a business with many types of credit accounts and many types of operations has a more complex calculation for net credit purchases.

    A baseline equation can be written as: Purchases = COGS + Ending Inventory - Starting Inventory

    Payment requirements also vary among suppliers. It is not always the case that a lower net credit purchases – which relates to a lower accounts payable turnover ratio – is a sign of poor debtor practices by the firm.

    Purpose of the Accounts Payable Turnover Ratio

    Analysts use the accounts payable turnover ratio and its cousin, the accounts receivable turnover ratio, to measure the liquidity and operational efficiency of a company. In a vacuum, a higher ratio is a sign of speedy payment for creditor services.

    This formula is very similar to the better-known accounts payable days formula. Lenders and suppliers are most interested in quality accounts payable practices, since they have to assume counterparty risk when fronting cash or materials to the firm.

  • How are net tangible assets calculated?

    Net tangible assets are listed on a company's balance sheet and indicate its book value based on the amount of its total assets less all liabilities and intangible assets.

    Net Tangible Assets

    Net tangible assets are calculated similar to a company's stockholders' equity. However, net tangible assets exclude the value of a company's intangible assets. To calculate a company's net tangible assets, subtract its par value of preferred shares and any intangible assets, such as goodwill, patents and trademarks, from its total assets.

    Calculating Net Tangible Assets

    For example, as of Dec. 28, 2014, Zulily Incorporated has total assets of $492.378 million and total liabilities of $216.415 million. However, Zulily does not have any intangible assets or goodwill. Since it does not have any intangible assets, this value is calculated by subtracting $216.415 million from $492.378 million. Therefore, its net tangible assets of $275.963 million is equivalent to its total shareholders' equity.

    On the other hand, as of Dec. 31, 2014 Facebook Incorporated has total assets of $40.184 billion, total liabilities of $4.088 billion, intangible assets of $3.929 billion and goodwill of $17.981 billion. To calculate the value of Facebook's net tangible assets, subtract its intangible assets, goodwill and total liabilities from its total assets. Facebook's resulting net tangible assets is $14.186 billion, or $40.184 billion less $4.088 billion, $3.929 billion and $17.981 billion.

    As of Dec. 31, 2014, Amazon.com Incorporated had total assets of $54.505 billion, total liabilities of $43.764 billion and goodwill of $3.319 billion. Its resulting net tangible assets is $7.422 billion, or $54.505 billion less $43.764 billion and $3.319 billion.

  • How are operating income and EBITDA different?

    EBITDA (earnings before interest, taxes, depreciation, and amortization) measures a company's profitability and is typically used to determine the earnings potential of a company.

    EBITDA removes the costs of debt financing as well as depreciation, and amortization expenses from profits. Also, EBITDA shows a company's profit without taxes and interest expenses on debt. As a result, EBIDTA can be beneficial since it provides a stripped-down view of a company's profitability from its core operations.

    Operating income is a company's profit after subtracting operating expenses. Operating expenses include selling, general and administrative expense (SG&A), depreciation, and amortization, and other operating expenses. Operating income is gross income minus operating expenses. Similar to EBITDA, operating income shows how much profit a company generates from its operations alone without interest expenses or tax expenses. However, EBITDA takes it one step further by striping out depreciation and amortization.

    Comparing EBITDA and Operating Income

    There are a couple of ways to calculate EBITDA, but one of the formulas is as follows:

    EBITDA = Operating Income + Depreciation and Amortization

    Since operating income is the net result of depreciation and amortization expenses being taken out, to calculate EBITDA, we need to add them back in. We can see the difference between EBITDA and operating income more clearly by looking at an example. 

    Below is the income statement for JC Penney Company Inc. (JCP) as of May 05, 2018.

    • Operating income was $3 million, highlighted in blue.
    • Depreciation was $141 million, but the $3 million in operating income includes subtracting the $141 million in depreciation and amortization. As a result, depreciation and amortization are added back into operating income during the EBITDA calculation. 
    • EBITDA was $144 million for the period or $141 million + $3 million.
    • We can see that interest expense and taxes are not included in operating income, but instead, are included in net income.

    JC Penney's EBITDA of $144 million was quite different from their operating income of $3 million during the same period. One metric is not better than the other. Instead, they both show the profit of the company in different ways by stripping out and inputting different numbers.


    Operating income includes overhead and operating expenses as well as depreciation and amortization. However, operating income does not include interest on debt and tax expense. Non-cash items like depreciation, as well as taxes, and the capital structure are stripped out when calculating EBITDA.

    It's important for investors to use multiple profit metrics when analyzing the financial statements of a company. EBITDA helps to strip out management decisions or possible manipulation by removing debt financing, for example, while operating income can help analyze the production efficiency of a retailer's core operations and expense management.

    But bear in mind that since depreciation and amortization are not in EBITDA, the profit of a company can get inflated. For example, if the company has sizable assets recorded as property, plant, and equipment, the depreciation expense would likely be quite large, and when added back in, it would boost EBITDA significantly.

    EBITDA can also be calculated by taking net income and adding back interest, taxes, depreciation, and amortization. Please note that each EBITDA formula can result in different profit numbers. The difference between the two EBITDA calculations might be explained by the sale of a large piece of equipment or investment profits, but if that inclusion is not specified explicitly, this figure can be misleading. As a result, both EBITDA formulas might yield slightly different results depending on whether you start with operating income or net income. Investors should be aware of what goes into each calculation and the components that make up the difference.

    For more on the different ways to calculate EBITDA including using net income, please read "What Is the Formula for Calculating EBITDA?"

  • How are profit margin and markup different?

    Profit margin and markup are two different accounting terms that use the same inputs and analyze the same transaction, yet they show different information.

    Typically, profit margin refers to the gross profit margin for a specific sale, which is revenue minus the cost of goods sold, but the difference is shown as a percentage of revenue.

    For example, if a company earned $3,000 in revenue and the cost to produce it was $1,000, the gross profit would be $2,000 and the gross profit margin would be 66.6% ($3,000 - $1,000) / ($3,000).

    Markup is the retail price a product minus its selling price, but the margin percentage is calculated differently.

    In our earlier example, the markup is the same as the gross profit, or $2,000, because the selling price was $3,000 and the cost was $1,000 to produce. However, the markup percentage is shown as a percentage of cost as opposed to a percentage of revenue with gross margin. 

    For example, using the same numbers as the example above, the markup percentage would be equal to ($3,000 - $1,000) / ($1,000), or 200%.

    Profit margin and markup show two different sides of the transaction. The profit margin shows the profit as it relates to the selling price or the revenue generated, whereas the markup shows the profit as it relates to the cost amount.

    Typically, markup determines how much money is being made on a specific item relative to its direct costs, whereas profit margin takes into consideration total revenues and total costs from various sources and various products.

  • How are retained earnings related to a company's income statement?

    Retained earnings appear on a company's balance sheet and may also be listed on its income statement. Retained earnings may also be published as a separate financial statement.

    The statement of retained earnings is one of the financial statements that any publicly traded company is required to publish on at least an annual basis. Retained earnings are essentially a company's bottom line net profit. They represent the company's remainder of earnings that are not paid out in dividends but are retained by the company to pay off existing debt or to be reinvested into company growth.

    Sometimes referred to as retained surplus, the calculation of retained earnings adds net income to beginning retained earnings and then subtracts all dividends that must be paid out to shareholders. The formula for retained earnings is as follows:

    Retained earnings = Beginning retained earnings + Net income - Dividends

    If a company has a net loss for the accounting period, a figure greater than the initial retained earnings, a company's retained earnings statement shows a negative balance or deficit.

    The retained earnings statement delineates changes in the earnings of a company over a given period of time, which may be as often as every three months, but must be produced at least once every 12 months. This financial statement reveals the surplus, or retained profit, between accounting periods. The retained earnings statement also reveals capital inflows and outflows.

    Retained earnings are an essential figure for investors and analysts in evaluating a company. Typically, companies use retained earnings to invest back into specific areas where growth opportunities appear most promising. Investors prefer to see consistent, year-to-year growth in a company's retained earnings. Most impressive to investors is a company that is able to steadily increase dividend payouts and still show steady growth in its retained earnings figure.

  • How are risk weighted assets used to calculate the solvency ratio in regulatory capital for Basel III?

    Risk-weighted assets are the denominator in the calculation to determine the solvency ratio under the provisions of the Basel III final rule. The solvency ratio, known as the risk-based capital ratio, is calculated by taking the regulatory capital divided by the risk-weighted assets. The solvency ratio determines the minimum amount of common equity banks must maintain on their balance sheets.

    Risk-weighted assets are a financial institution's assets or off-balance-sheet exposures weighted according to the risk of the asset. Basel III increased the amount of common equity the banks must hold. For example, under Basel III, banks are required to hold 4.5% of common equity of risk-weighted assets, with an additional buffer of 1.5%. The common equity percentage increased from Basel II, which only required 2%.

    Basel III is a comprehensive regulatory measure passed in the wake of the 2008 credit crisis that seeks to improve risk management for financial institutions. Basel III changed how risk-weighted assets are calculated. Under Basel III, U.S. government debt and securities are given a risk weight of 0%, while residential mortgages not guaranteed by the U.S. government are weighted anywhere from 35 to 200% depending on a risk assessment sliding scale. Under Basel II, residential mortgages had a flat risk weighting of 100% or 50%.

    Basel III increased the risk weighting for certain bank trading activities in particular, especially swaps trading. Some argue that Basel III has placed undue regulations on banks for these trading activities and has allegedly reduced their profitability. Basel III encourages the trading of swaps on centralized exchanges to reduce counterparty default risk, often cited as a major cause of the 2008 financial crisis. In response, many banks have severely curtailed their trading activities or sold off their trading desks to non-bank financial institutions.

  • How are the three major financial statements related to each other?

    The information found on the financial statements of an organization is the foundation of corporate accounting. This data is reviewed by investors and lenders for the purpose of assessing the company's level of financial stability. Data found in the balance sheet, the income statement and the cash flow statement is used to calculate important financial ratios that provide insight into how the company's finances are being managed and potential issues that may need to be addressed. Investors are able to make well-informed investment decisions based on what a company provides in its financial statements each period. The balance sheet, income statement and cash flow statement provide different information on a company's financial position, but these accounting staples are all interconnected.

    The Balance Sheet

    Also referred to as the statement of financial position, a company's balance sheet provides information on what the company is worth. The balance sheet reports the totals of a company's assets, liabilities and shareholders' equity on a specific date, and it mimics the accounting equation expressed as assets = liabilities + shareholders' equity. An asset of a company can only be obtained through shareholders' equity or by taking on a liability, such as a bank loan or line of credit, so the balance sheet reflects the direct relationship between these transactions. Instead of showing individual accounting transactions, the balance sheet acts as a snapshot of the company's accounts at the end of an accounting period. An increase or decrease in assets due to profit or loss is transferred to the balance sheet directly from a company's income statement.

    The Income Statement

    A company's income statement reports the level of revenue a company earned over a specific time frame as well as the expenses directly related to earning that revenue. Companies first list gross revenue from product or service sales, and then subtract any money not expected to be collected on specific sales due to returns or sales discounts. This results in the company's net revenue. All expenses related to the cost of sales are subtracted from net revenue to reach gross profit. All operating expenses are then deducted from that total, resulting in operating profit before interest and income tax expenses. Net earnings or losses are listed as the bottom line of the income statement after expenses for interest and taxes are deducted. Any increase or decrease in assets due to profit or loss reported on the income statement is transferred to the balance sheet, and total profit or loss reported on the income statement is included in the statement of cash flow under cash flows from operations.

    The Cash Flow Statement

    The cash flow statement reports any cash inflow or outflow over the course of the accounting period. This financial statement highlights the net increase and decrease in total cash on hand for the accounting period. The cash flow statement is broken down into different sections, including operating, investment and financing activities. The information in the cash flow statement explains changes shown in the numbers reported on the balance sheet, and it explains transaction level changes in net profit or loss as reported on the income statement.

  • How can a company buy back shares to fend off a hostile takeover?

    There are several reasons why a company may choose to repurchase some or all of the outstanding shares of its stock. This move, called a stock buyback, can serve as a way to consolidate ownership, reward shareholders for their investments, boost important performance metrics or even to increase executive compensation.

    Executing a stock buyback can also be a strategic maneuver used to fend off hostile takeovers. In fact, this strategy was once so popular that many companies, to prevent investor panic, would specifically state that newly announced buybacks were not a result of a takeover attempt.

    A takeover occurs when one company, called the bidder, seeks to acquire another company, called the target, by purchasing enough shares of stock to have a majority stake in the company. Since each share of stock represents a portion of company ownership, owning more than half of the outstanding shares essentially means the bidder owns the target company. If the target company does not want to be acquired, the takeover is considered hostile.

    One way that target companies attempt to fend off hostile takeovers is to make the business less valuable to a potential bidder. When a company acquires another, any assets of the target company are used to pay off its debts after the acquisition. By using any cash on hand to repurchase stock, the target company effectively reduces its asset total. This means a bidder would need to use other assets to meet the target's financial obligations.

    For example, assume company ABC's balance sheet shows assets totaling $1 million, of which $500,000 is cash. Further assume that the company has debts totaling $400,000. If company XYZ acquires ABC in its current state, the $500,00 in cash can be used to pay off this debt in its entirety, leaving $100,000 that can be used for other purposes. For XYZ, this means that the potential liabilities associated with acquiring ABC are limited since it has more assets than debts.

    However, if ABC uses that cash to repurchase shares of stock, then that $500,000 is returned to shareholders and is no longer part of the asset total. If XYZ acquires ABC under these conditions, it must either use its own assets or liquidate some of ABC's remaining assets to pay off its debts. Clearly, ABC is a much less desirable target in this scenario.

    Stock buybacks also limit the ability of the bidding company to purchase the necessary number of shares by decreasing share availability and increasing the price per share. Those shareholders that decline a repurchase offer are likely those who have a considerable stake in the company and do not want to give it up. If a buyback eliminates all other shares but those owned by this type of highly invested shareholder, then the bidding company has a much more difficult time acquiring the requisite 50% since the remaining shareholders are unlikely to sell.

    Lastly, reducing the number of shares outstanding forces the bidding company to make a formal announcement about its takeover bid sooner. The Securities and Exchange Commission, or SEC, requires businesses to announce publicly when they have acquired more than 5% of another company's stock. A stock buyback, therefore, ensures that a target company receives early warning of a potential takeover threat by lowering the 5% threshold.

  • How can a company have a negative gross profit margin?

    Gross profit margin shows how well a company generates revenue from the direct costs like direct labor and direct materials involved in producing their products and services. 

    Gross profit margins turn negative when the costs of production exceed total sales. This could be an indication of a firm's inability to control costs. On the other hand, negative margins could be the natural consequence of industry-wide or macroeconomic difficulties beyond the control of company's management.

    What Is Gross Profit Margin?

    Gross profit is the revenue earned by a company after deducting the direct costs of producing its products. For example, if it costs $8,000 to manufacture a car, and the finished product sells for $24,000, the difference of $16,000 is the gross profit.

    Gross profit is calculated by subtracting the cost of goods sold from total revenue. If the resulting gross profit figure is divided by revenue, you are left with the gross profit margin. This number demonstrates what percentage of revenue eventually becomes gross profit.

    Reasons for a Negative Gross Profit Margin

    A negative gross profit margin can occur when the costs exceed the revenue generated from the sale of the product. There are several reasons why a company might experience a negative gross profit margin, and some of them are outlined below. 

    Revenue Declines

    Declining sales could lead to revenue declines, while costs remain the same or become elevated.

    Poor pricing of a product could lead to a lower-than-expected profit per item and ultimately lead to a loss.

    Poor marketing for a new product launch could lead to declining revenues and a loss. For example, if a company manufactured a new product ahead of its launch, and the sales were lackluster, the company would be stuck with the inventory. The company may need to reduce the price of the product to move the excess inventory and get saddled with a loss.

    Increased competition could force a company to cut its prices to maintain its customer base and market share. As a result, revenues would decline, and a loss could incur since costs would likely remain the same.

    Cost Increases

    Raw material cost increases can wipe out profits and lead to a loss. For example, if a company signed a contract to deliver its product to a customer and the price of the raw materials increased, exceeding the price of the product, gross margin would be negative.

    Labor cost increases can lead to a higher-than-expected cost of goods sold. For example, if a company experiences delays in getting an order out for a large customer, management might have to pay employees overtime or hire additional help to get the order filled.

    Macroeconomic Shock

    A recession can reduce profits for companies as consumers reduce spending and businesses scale back operations. For example, home builders and construction companies might experience negative gross profit margins following the collapse of the housing market. The excess inventory of homes would likely be sold for a loss if the recession was severe enough, as in the case of the Great Recession. 

    A substantial rise in interest rates can have a negative effect on some industries. For example, if rates rise too quickly, auto manufacturers might suffer from lower sales, since many consumers finance or borrow to purchase a new car. Higher interest rates might cause consumers to be unable to afford the car payment, and the result is excess inventory for car makers, leading them to sell their cars for a loss to unload their inventory.

    How to Interpret Negative Gross Profit Margin

    Gross profit margin should be interpreted within the context of the industry and past company performance. Otherwise, a negative margin could mislead you into believing that management made mistakes or failed to control costs. Many well-run companies can experience a loss in the short-term, such as travel companies and airlines following 9/11. If a company's management makes adjustments, or the exogenous shock abates, profitability could return. However, if there's a pattern of losses over several quarters, it may be an indication of a more systemic long-term problem. 

    For more on profit margins, please read "What Is Considered a Healthy Operating Profit Margin?"

  • How can a company raise its asset turnover ratio?

    The asset turnover ratio measures a company's efficiency and productivity. A company can increase a low asset turnover ratio by continuously using assets, limiting purchases of inventory and increasing sales without purchasing new assets. The asset turnover ratio indicates the amount of revenues, or sales, a company generates for each dollar of assets. It is calculated by dividing a company's sales by its total assets. The higher the asset turnover ratio, the more efficient a company. Conversely, if a company has a low asset turnover ratio, it indicates it is not efficiently using its assets to generate sales.

    For example, assume company ABC and company DEF are both big-box retailers. Company ABC earned $500,000 in sales and had total assets of $3 million. Company ABC's resulting asset turnover ratio is 0.17. Therefore, for every $1 worth of assets, the company only earns 17 cents in revenues.

    On the other hand, company DEF earned $500,000 in sales and had total assets of $200,000. Company DEF's resulting asset turnover ratio is 2.50. Therefore, for every $1 worth of assets, the company earns $2.50 in revenues.

    Company ABC can increase its asset turnover ratio by continuously using its assets and not letting its merchandise build up in storage. Rather, company ABC should always keep its shelves fully stocked with saleable items at all times. It should also limit purchases of inventory until it needs it. Company ABC could increase its asset turnover ratio by only purchasing new inventory when most of its items are bought.

    Company ABC may also look to increase its sales by staying open 24 hours a day to efficiently use its assets around the clock. Therefore, the company has the potential to generate more sales.. The company could also look to reduce its assets by closing some of its stores that have not been efficiently generating sales or that have been operating at a loss.

  • How can average investors get involved in an IPO?

    An initial public offering, or IPO, is the first sale of stock by a new company, usually a private company trying to go public. An IPO often serves as a way for companies to raise capital for funding current operations and new business opportunities. To get in on an IPO, you will need to find a company that is about to go public. This is done by searching S-1 forms filed with the Securities and Exchange Commission. To participate in an IPO, an investor has to be registered with a brokerage firm. When companies issue IPOs, they notify brokerage firms, which in turn notify investors. 

    Most brokerage firms require that investors meet some qualifications before they can participate in an IPO. Some brokerage firms might specify that only investors with a certain amount of money in their brokerage accounts or a certain number of transactions can participate in IPOs. If you are qualified to participate in IPOs, the firm will usually have you sign up for IPO notification services, so that you are alerted when there are any new IPOs that meet your investment profile. If you are interested in participating in an IPO, contact a brokerage firm and ask for its requirements.

    This question was answered by Chizoba Morah.

  • How can EV/EBITDA be used in conjunction with the P/E ratio?

    Because they provide different perspectives of analysis, the EV/EBITDA multiple and the P/E ratio can be used together to provide a fuller, more complete analysis of a company's financial health and prospects for future revenues and growth.

    The EV/EBITDA Ratio

    The EV/EBITDA ratio compares a company’s enterprise value to its earnings before interest, taxes, depreciation and amortization. This metric is widely used as a valuation tool; it compares the company’s value, including debt and liabilities, to true cash earnings. Lower ratio values can indicate that a company is currently undervalued.

    This ratio differs from the price-earnings ratio because it is not affected by any changes in capital structure. It allows analysts and investors to make more accurate comparisons of companies that have differing capital structures.

    This metric is also exclusive of noncash expenses, such as amortization and depreciation. Investors are often less concerned with noncash expenses and more focused on cash flow and available working capital.

    The Price-Earnings Ratio

    The P/E ratio is a ratio of market price per share to earnings per share (EPS). One of the most used and accepted valuation metrics, the P/E ratio provides investors with a comparison of the current per-share price of a company to the amount the company earns per share. Ultimately, this metric is ideal for helping investors understand exactly what the market is willing to pay for the company’s earnings, and thus the market's overall consensus on the company's future prospects. Higher P/E ratio values generally indicate that the market expects share prices to continue to rise.

    Higher P/E ratios are not always positive, however. High ratios may be the result of overly optimistic projections and corresponding overpricing of shares. Also, earnings figures are easy to manipulate, because this ratio takes non-cash items into consideration. Thus, it is often advisable to use this metric in conjunction with metrics such as EV/EBITDA to obtain a more complete and accurate assessment of a company.

  • How can I access a company's earnings report?

    One of the most important tools in the arsenal of the fundamental investor is the company earnings report. The earnings report is a public display of financial standing and the official word on recent business performance. All publicly traded companies are legally required to file quarterly reports, annual reports, and the 10-Q and 10-K reports. Current and potential shareholders can track coming earnings releases through the Nasdaq online earnings calendar. Released earnings reports can be found through SEC.gov and other publications, such as the Yahoo Finance earnings calendar.

    Track Coming Reports Through Nasdaq

    The Nasdaq earnings calendar presents a clean, no-frills collection of coming earnings reports. You can search companies based on a specific release date or by ticker symbol, and the website will give a brief overview of key information.

    For example, you can see reports released on the day you visit the website, complete with market caps, consensus earnings per share (EPS) forecasts and last year's EPS. Click on the company name to see the report.

    SEC Website

    The most authoritative, complete and boring resource for all earnings reports is SEC.gov, where you can search for any publicly traded company and read every quarterly, annual and 10-Q and 10-K reports.

    Many people confuse the quarterly earnings report with the 10-Q because they are both based on quarterly data. However, the 10-Q is a much longer document, filled with black-and-white financial information. While this can make it tedious to read, investors can avoid the fluff of the official earnings report. The 10-K and annual earnings reports have a similar relationship.

    Listening to Earnings Conference Calls

    All earnings calls are open to the entire public – by law, not necessarily by company choice. All can be accessed via telephone; the number is required on the company website. These can provide an even better insight than quarterly earnings reports.