Finding the after-tax cost of retained earnings (rr)

The cost of retained earnings is the same as the cost of new common stock less flotation costs. Therefore, it is cheaper for businesses to use retained earnings compared to issuing new common stock.

Retained earnings are already earnings after-tax. Therefore, no tax adjustment is required when calculating the cost of retained earnings.

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Calculating net profit after tax

In summary, to calculate net profit after tax, we need to subtract cost of goods sold, operating expenses, interest and tax from the sales revenue.

To make this calculation, we need to understand the format of the income statement.

Income Statement Format


Sales revenue

LESS: Cost of goods sold

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

Therefore, to calculate net profit after tax, all we need to do is to subtract cost of goods sold, operating expenses, taxes and interest from sales revenue.

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Calculating net profit before tax

In summary, to calculate net profit before tax, we need to subtract cost of goods sold, operating expenses and interest from sales revenue. We need to understand the format of the income statement.

Income Statement Format


Sales revenue

LESS: Cost of goods sold

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

Therefore, to calculate net profit before tax, all we need to do is to subtract cost of goods sold, operating expenses and interest from sales revenue.

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Calculating gross profit

Calculating gross profit is simple and straightforward. In summary, we need to subtract cost of goods sold from the sales revenue.

Whilst making this calculation, we need to have a good understanding of the format of the Income Statement, as shown below. More details can be found in the format of the income statement section.

Income Statement Format


Sales revenue

 

LESS: Cost of goods sold

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

Therefore, all we need to do is to subtract cost of goods sold from the sale revenue. But how do we find the cost of goods sold? To calculate the cost of goods sold, we need to take the following steps:

Cost of goods sold =

Opening inventory

ADD: Purchases

LESS: Closing inventory

Gross profit allows us, among other things, to calculate the Gross Profit Margin Ratio , which is:

Gross Profit Margin = Gross Profit / Sales GPMR measures how much of each sales dollar is remaining after costs of goods are deducted. In other words it measures the relative cost of goods sold.

Income Statement Format

Familiarity with the income statement format is important for anyone who wants to succeed in business studies and a business career. You need to be familiar with the format to the point of being able to write down the format from memory.

The income statement, which is also referred to as profit and loss statement (P&L), is one of the most important financial statements. Other important financial statements include the balance sheet, cash flow statement and statement of changes in equity.

A good way to compare the income statement, balance sheet (financial position statement) and cash-flow statement is to think of a river leading to a dam. The income statement and a cash-flow statement record the movement of money over a specific period of time. It is similar to recording the volume flowing down a river over specific period. The balance sheet (financial position statement) is the dam. Everything collects there.

The income statement calculates if the business generated a profit or incurred loss during a specified financial period. In other words, it shows profitability of the organization over a certain period.

If profit was generated during then the bottom line of the statement will be a net profit after taxes, which is also called the net income. The general format is presented below.

General income statement format


Sales revenue

LESS: Cost of goods sold*

= Gross profit

LESS: Operating expenses

= EBIT (earnings before interest and tax/operating profit)

LESS: Interest

= Net profit before tax

LESS: Taxes

= Net profit after tax

LESS: Preferred stock dividends

= Earnings available for common stockholders

To calculate Cost of goods sold, one needs to follow the steps:

Opening inventory

Add: Purchases

Less: Closing inventory

= Cost of goods sold