[MUSIC] Understanding how operating profit is formed. An analysis of margins on a historical basis, and relative to competitors and industry benchmarks, provides a comprehensive understanding of a company's strategic position. Revenues of sales, this is the total amount of goods sold or services provided during a specific period. Understand that it is not the amount of money that your company will actually receive during the period, because payments may be received after the closing date. Costs are allocated to the main corporate functions. Cost of goods sold to production, selling and marketing costs to commercial. Research and development costs to research, general and administrative costs to administration. Personnel expenses is allocated to each of these four categories. How to calculate cost of goods sold, COGS. We first start with a commercial business. Opening inventories plus the amount of inventory purchased over the period gives you the total amount that could have been sold. Sometimes known, understandably, as cost of goods available for sale. If an item is not in inventory at the end of the period, it must have been sold. Therefore, COGS = opening inventories + inventory purchases- closing inventories. For a manufacturing business we proceed as above but instead of considering only inventory purchases, we use all the direct costs attributable to the production of the goods sold by the company. This amount includes the cost of the materials used in creating the goods along with the direct labor costs used to produce the goods. How to calculate gross margin? Gross margin = revenues- COGS. How to calculate EBITDA? From the gross margin, one needs to deduct the SG&A expenses and R&D expenses to get to EBITDA. Selling, general, and administrative expenses, SG&A, are non-production costs which break down to selling expenses, cost incurred to market and distribute its products, general and administrative expenses, overhead expenses not directly associated with the sale of goods. EBITDA equals earning before interest, taxes, depreciation, and amortization. How to calculate EBIT? If depreciation equals write-off of tangible assets, EBIT equals earnings before interest and taxes. But, after depreciation, equals operating profit. The cascading matrix in the video from revenue to gross margin to EBITDA to EBIT are often used to measure margins, the ratio of earnings to sales. The video left out an important metric, the net operating profit after tax, or NOPAT. This is because NOPAT is involved in the measure of profitability, not margin. The ratio of profits to the operating assets needed to generate profits. NOPAT is an operating performance measure after taking account of taxation but before financing costs. That is to say, interest is excluded. I cannot over-emphasis the importance of the two following accounting equations. NOPAT=EBITx(1-Normalized Tax Rate). NOPAT=Net income + net financial expenses after tax. Remember that we called operating assets the addition of your venture's fixed assets and its working capital requirements. Operating assets are the assets needed to generate NOPAT. We can show that operating assets are equal to invested capital or capital employed, which we define as equity plus net debt. Net debt include net short debt plus long-term debt. This is a fundamental identity, operating assets equal invested capital, or capital employed, equal equity plus net debt. The return on operating assets is one way of considering profits in relation to operating assets needed to generate them. It has standard to become the main measure of economic performance. Return on operating asset is NOPAT over operating assets. But because there is no miracle in finance, the profitability is also the ratio of profits to the capital that had to be invested to generate the profits. This ratio is called the return on capital employed, or ROCE, or return on investment capital, or ROIC. Return on capital employed is not part of the capital employed. It is quite intuitive that invested capital has a cost. To measure value, returns must be compared with the cost of capital employed. Value has been created when return on capital employed is higher than the cost of capital employed. Value has been destroyed when return on capital employed is lower than the cost of capital. Capital budgeting is a decision making process for investing in operating asset. The basic principle of capital budgeting is that the comparison between ROCE and cost of capital determines whether or not an investment is worthwhile. [MUSIC]
