Gross profit margin – Meaning & Formula

Gross profit margin is one of the profitability ratios used to gauge the general profitability of a firm. This ratio represents the relationship between gross profit and net sale of a firm. The main usability of this ratio is to measure the effectiveness of firm to generate profit out of its sale.

Gross profit margin is also known as ‘Gross margin’.

Formula for calculation of gross profit margin:

Gross margin is calculated by dividing the amount of gross profit by net revenue (net sale).

Gross profit ratio = Gross profit/ Net sale

Gross profit is calculated by deducting the amount of cost of goods sold from net sales. Therefore, below formula can also be used in calculation of gross profit ratio

Gross profit ratio = (Sales – COGS)/ Net sales

Cost of goods sold (COGS) = Opening stock + Purchases – Closing stock

The higher degree of this ratio shows that management is effectively generating profit while incurring lower cost of goods sold.

Deduction – An important step of O2C process

Deduction is one of the important steps in order to cash cycle which is the complete process, every business enterprise follows.

This step comes into picture when an invoice has been raised and sent to customer which the customer does not pay in full. The personnel involved in this process then raises a new invoice with the amount so settled between customer and company.

For a business enterprise, deduction reduces total amount of sales and hence lead to lower profit. It also increases the total wastage of time for personnel involved in this process.

Reasons for deduction

The main reason for adjusting the amount of an invoice is settlement of trade promotion. Trade promotion is a technique used by companies to attract more retailers and partners.

Deduction is made in payment by customers as a result of poor quality of product, delay in shipment, incorrect invoice raised to customer, return of product by customer or any other reasons.


Days sales outstanding – Meaning & Calcualtion

Days sales outstanding (DSO) is the calculation of average number of days which a company takes in collection of its account receivables. This is an important element of order to cash cycle and it increases the cash flow of company.

DSO is used to check how many days it takes to collect the amount of credit sales during a period. Usually, this figure is calculated for month, quarter or year, however there is no such obligation in this regard.

How days sales outstanding (DSO) is calculated?

DSO is calculated by multiplying the account receivable to the number of days for which DSO is being calculated and dividing the figure by total credit sales made during that period.

Formula:

(Accounts receivable × Number of days) / Total credit sales

Lower value of DSO indicates that the company is more efficient in collecting the amount incurred by credit sales.

Credit Memo – Definition & Reasons

Credit memo (short form of credit memorandum) is a document which is issued by the seller to buyer for adjustment of amount for an invoice. The document can be issued for any of the below reasons:

Reasons for issuing credit memo:

  1. For not delivering the goods or services.
  2. Product is returned by the buyer
  3. To adjust the amount which has already been received by seller through previous invoice
  4. For any discount given/ price change after invoice is raised.
  5. For any other reason by which buyer is paying partial amount to seller.

Credit memorandum usually contains the information like purchase order (PO) number, date of invoice issued, amount of invoice, reason for which credit memo is issued along with the adjusted amount.

The aggregate of credit memorandum is later used to check various reasons for which these notes were issued by the company.

Credit memos which are yet to be issued (Opened credit memos) can be used to offset the amount of account receivable.

Credit memo is also known as ‘credit note’.

Employee stock option plan v/s Employee stock ownership plan

Employee stock option plan and employee stock ownership plan are considered as one but these two terms are very different.

Employee stock option plan v/s Employee stock ownership plan:

Employee stock option plan

Employee stock option plan is a contract between a company and its employees that gives employees the right to buy company’s shares at grant price. Grant price (also known as exercise price) is the price which is decided by the company. This right can be exercised within time frame imposed by the company and only a fixed number of shares can be purchased by the employee.

Employees get benefited from this plan when market price of shares are higher than the grant price.

Employee stock ownership plan

Employee stock ownership plan is a retirement plan in which an organisation distributes its share among its employees. These shares are held in common account and transferred to the employee’s account upon entitlement. In this plan, employees never purchase the shares directly or indirectly. These shares are transferred to employees account when they retire/ terminate from the company.

Employee stock ownership plans are used by companies for a number of reasons. For example to keep the morale of employees higher.