Analysis of Financial Statements – Gross Profit – Gross Margin Trends and Operating Expense Analysis

Gross profit usually reflects the type of industry in which the company operates. Once the net sales and cost of goods sold are calculated, it is a simple matter to determine the gross profit which is the difference between the two.

Gross margin trends: The credit analyst should investigate sharp changes in gross margin levels. Deteriorating margins indicate purchasing difficulties, manufacturing inefficiencies or inventory accumulation. Acceptable gross margin levels vary among industries, so as to assess the sufficiency of margins which, includes a comparison with others in the particular market or industry. Gross margin trends usually are best compared as percentage trends and not rupee trends.

Operating expense analysis: Operating expense represents costs not directly related to the production of goods and services. Wages paid to a laborer to shipping products, for example, are considered as cost of goods sold expenses. On the income statement, operating expenses include salaries, selling expenses and general and administrative expenses. However, the borrower usually can supply a more detailed breakdown of operating expenses, listing among other things, salaries by type of personnel, auto expenses, insurance, repairs and maintenance, telephone and entertainment, profit sharing, legal, accounting, advertising and postage costs.

Operating expenses are a reflection of management decisions, because the owner has more control over operating expenses than cost of goods sold. Trends in this area give the credit analyst some insight into management’s style and ability to adjust to change.

Operating income(loss) is calculated by subtracting the total operating expenses from the gross profit. An operating loss occurs if the total operating expenses exceed the gross profit.

Non controllable and controllable expenses:
Operating expenses are subdivided into non controllable and controllable expenses. Non controllable expenses include rental payments, long term lease obligations, salaries, marketing costs and office expenses including rental payments, long term lease obligations, salaries, marketing costs and office overhead expenses. For example, once a decision is made about as to where to rent or lease space, there is little a company can do to control that cost.

Controllable costs include bonuses, profit-sharing plan costs, the travel and entertainment budget and automobile or other short term leasing costs. Segregating non controllable and controllable expenses helps the credit analyst to identify the costs that must be covered for the company to remain in business and the costs that could possibly be reduced in order to improve the profitability.

Another way of measuring as to whether costs are reasonable is to calculate the operating expenses as a percentage of sales and compare them to a similar company or to the industry average.

Interest expense:
Interest expense is a recurring expense that fluctuates in coordination with market interest rates and the amount of company debts.
Interest expense: Interest expense is a recurring expense which fluctuates in coordination with market interest rates and the amount of company debt.

Other income and expense analysis:
Income and expenses falling outside the normal business operations are listed in the other income and other expense accounts on the income statement.

The possible sources of other income are the profit from the sale of fixed assets, interest income and renting excess facilities and equipment. Other expenses include the losses on the sale of fixed assets, losses on the sale of stock of discontinued operations and interest expense.