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Accounting - A Definition What is accounting all about?

Accounting: A word that everyone has heard or a word that many of us hear so many times without knowing really what it is. Common Misconceptions about accounting

1. There is often the misconception that accounting is all about counting, that is adding, subtracting, multiplying and dividing. I have seen ads on papers where accounts clerk or even assistant accountant are required with simply good grades in Maths. Partly true but not almost! 2. Accounting is about recording receipts and payments of money. Again partly true. Accounting does record in terms of money but not only receipts and payments of money. 3. Accounting and book-keeping are the same. NO! Book-keeping is simply a part of accounting. Bookkeeping is that part that consist of recording financial business transactions in books or on computers. 4. Accounting is a recent invention as required by recent development in the business environment. FALSE The foundations of modern accounting can be traced back to 1494 when Luca Pacioli published his book Summa explaining the double entry system as practiced in Venice at that time. (Source: http://www.canhamrogers.com/HDEB.htm). However, personally, I believe accounting has existed ever since the caveman drew pictures of animals in his cave. Accounting even existed when slates made of clay were used and also when the papyrus was invented. This is because the basic purpose of recording information on the cave wall, on the slates and on the papyrus were the same as today businesses are recording information in books and computers. The ways of recording have changed to suit the needs of businesses in their respective era, thus making accounting a dynamic subject and making accountants lifelong learners.
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is accounting then?

Of starting a small business

But

what

Before we move to a technical definition of accounting, let us ask ourselves a few questions: 1. What is a business?

A business is any entity set up so that the entrepreneur earns profit. This is usually done by buying and selling goods or making and selling goods or offering paid services. A person who sets up a business is called an entrepreneur. 2. Why do we do business?

As said in the answer to question 1 to earn profit. Non-profit making organisations are not called businesses. 3. Then, what is profit?

Profit is the surplus of revenue over expenditure. Of course, an entrepreneur will sell goods at prices higher than their cost so as to cover other business expenses and make a profit. An entrepreneur lives on the profit he earn by doing business. 4. Total How Revenue is Total profit Expenses = calculated? Profit

Of course, in accounting things may look a bit complicated but in fact they are as simple as above. 5. Where do we get such information to calculate profit?

This is where it is important to record transactions. Examples of revenue are sales, interest received and discount received while expenses include cost of goods, salaries and wages, electricity and water consumption, telephone bill, insurance among others. 6. How do we record?

Since we need information separately, we need to record in such a way so as to get information quickly. In other words, we have to be systematic and methodical in the way we record our financial information. In modern accounting we use the double entry system. 7. Why should we know about our profit?

Can someone imagine working somewhere and ignores what he/ she earns as salary. What if one month salary is missed? What if the employer is paying too little? All employees do check whether salaries earned are received in due time. Also, salaries are compared with salaries paid by other organisations for similar jobs and obviously any discrepancy may imply a decision is to be taken. Precisely, an entrepreneur has some expectations when setting up a business. Based on his financial needs, he would expect a level of profit that would not only satisfy his needs but also ensure the growth of his business. Besides, any rational entrepreneur would like to have an increasing profit trend year after year. Therefore, it is important to calculate profit at regular interval to assess the health of the business. In the same way, it is important to keep records of other items so as to make analysis for proper decision making. 8. What if we want to invest in a company?

Instead of starting a small business one can invest in shares of other companies. For that, one will look for a profitable company where earnings in terms of dividend are more likely to be high and this is done by comparing accounts of different companies. However, for account of different companies to be comparable, they have to be prepared using the same principles. In accounting these principles are called Generally Acceptable Accounting Principles. From i) the above, one Recording can find that of accounting is about 3 main things:

financial

information

ii) iii) Now

Organise Analyse putting

information

in information

systematic for

and

methodical

way making.

decision we can say

all

three

together

that:

Accounting is the recording of financial transactions in an organised way so that information can be extracted, analysed and reported for decision making.

A business starts A business is an organisation set up with the aim of earning profit by providing goods and/ or services - a trading business and a service business respectively. A business may be owned by one single individual (called the proprietor in a sole trading business) or a group of persons (called partners in a partnership or shareholders in a company). For convenience, we shall be referring to a business as a sole trading business - partnerships and companies will be used only when dealing with chapters on partnership and limited liability companies respectively or any other relevant chapters. A business is born when the proprietor decides to do business. As from this point, the owner and the business are considered as two different persons distinct from each other. However, the business is not a human being and so will not be able to operate on its own. The owner acts as an agent for the business - anyway it is his business and he will own all that the business earns.
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That is why the Business Entity Concept treats a business as distinct and separate from its owner. According to this concept, it is important to record the transactions, assets and liabilities of the business separate from its owner's personal transactions, assets and liabilities.

Accounting

Equation

The accounting equation can be considered as the foundation of financial accounting. It shows ,on one hand, the resources owned by the business and, on the other hand, claims over the assets (how the assets are financed or who supplied the assets).

What the business has Assets

= how they are financed = Owners Equity + Liabilities

Assets refer to all that a business possesses and that have money value. Obviously, these assets have been obtained from the owner or were bought later. Examples of assets are:

Building, Vehicles, Furniture, Equipment, Inventory (Stock of Goods), Trade Receivables (debtors or amount owed by credit customers), Other Receivables (prepayment of expenses), cash equivalents (money at bank) and cash in hand. At the very beginning of most businesses, all assets are supplied by the owner as his initial investment. In most cases, the initial investment is in the form of cash (though in other cases it can be in form of other items like building, furniture or vehicles etc). Capital represents the claim that the owner has over the assets of the business. The owner has a claim over what he invested in his business. Should he stop doing business one day, he expects to get back what the amount he invested together with the profit. Therefore, it can be said that the business owes its owner the amount the latter invested in the business. Liabilities refer to the amount that the business owes to other persons other than the owner. Such persons include credit suppliers and banking institutions. They have a claim on the assets of the business to the amount they have given credit facilities or they have lent. Let us consider the following case:

Bill started business on 1st January as a computer reseller. He invested $100 000 cash which he took from his past savings. Now, remember that, as from this point, Bill and his business are considered as two different persons (see business entity concept). Therefore, now the $100 000 belongs to the business, though Bill has a claim over it. Hence:

We have seen above that what the business has is called an asset. Therefore, the asset of Bill's business is cash of $100 000. The claim that an owner has over its business is called capital or owners equity This gives us the following equation:

On 2nd January, Bill bought computers for resale (goods in this case) on credit from Sam for $25 000. On one hand the business is receiving goods. Now, anyone would agree that whatever you buy, whether for cash or on credit, belongs to you. In the same way, the business has bought computers for resale. So, the computers belong to the business. Therefore, Note: assets Goods of the for business resale now include are inventory termed costing as $25 000.

Inventory.

On the other hand, given that goods were bought on credit, the business owes Sam, a credit supplier, $25 000. Sam being an outsider to the business, the amount owed is a liability. Therefore, the liabilities of the business now include trade payables amounting to $25 000. Note: Hence: Amount owed to a credit supplier is termed as Trade Payables.

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This gives us the following equation:

The validity of the Accounting Equation can be tested with any transaction. It shall always hold. Besides, the accounting equation is applied in the Balance Sheet.

Ledger
The ledger is a special book in which transactions are recorded. In other words, a book in which accounts are kept. The ledger differs from other books in the way columns are drawn to record transactions as follows:

Dr Date Details

The Ledger Folio Amount Date $ Details

Cr Folio Amount $

Types of ledger:
In a real business, there are so many accounts to keep and each account may need lots of space to record transactions for the whole accounting year. For this reason, a business usually keeps, not one, but several ledgers. These ledgers are classified into three types:

Sales Ledger
The book (or set of books) in which the personal accounts of credit customers are kept.

A credit customer is also called a debtor. The balance of a customers account shows the amount that the customer owes the business. Therefore, the total of balances in the sales ledger is the total amount the business is owed by its credit customers. This amount is called trade receivables or accounts receivables. Trade receivables is shown as a current asset in the balance sheet.

Purchases Ledger
The book (or set of books) in which the personal accounts of credit suppliers are kept. A credit supplier is also called a creditor. The balance of a suppliers account shows the amount that the business owes the supplier. Therefore, the total of balances in the purchases ledger is the total amount the business owes by its credit suppliers. This amount is called trade payables or accounts payables. Trade payables is shown as a current liability in the balance sheet.

General Ledger
The book (or set of books) in which all other accounts are kept.

Types of Accounts
An account records changes to a specific item. For example: The cash account records changes in the amount of cash available in hand. The bank account records changes in the amount of cash held at the bank. Furniture account records changes in the values of furniture owned by the business etc.

Just as the ledger has been classified into different types, accounts also are classified into different types as below:

Personal accounts
As the name says, personal accounts are accounts of persons. They, therefore, bear the names of persons. Such persons can be credit customers or credit suppliers. Therefore, personal accounts are kept in either:

Sales ledger, or Purchases ledger Note that in accounting, persons here refer not only to individuals but also to companies, partnerships or any form of organisation with whom there was a transaction.

Impersonal accounts
As seen in the above diagram, impersonal accounts are of two types: Real accounts Nominal accounts All impersonal accounts are kept in the general ledger.

Real accounts
Real accounts record property/ assets of the business. Examples of real accounts are: furniture account, building account, vehicles account etc

Nominal accounts
Nominal accounts record liabilities, expenses, revenues, capital and drawing. Examples of nominal accounts are loan account, sales account, commission received account, salaries account, rent account, capital account, drawings account etc
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Relationship between types of ledger and types of accounts

Accounting Concepts

The preparation of Income Statement and Balance Sheet of a business is based on certain assumptions. These assumptions are called Accounting Concepts. Accounting concepts are very helpful in applying commonly established procedures in preparing financial statements. Below is a list of basic accounting concepts: Going Definition It is assumed that the business will continue to operate in the foreseeable future (as far as one can predict). Therefore, there is no intention of closing down. This concept may not be applied if there are evidences or conditions requiring the ceasing of business for example persistent losses or liquidity problem. Implication Assets are valued at historical cost less aggregate depreciation and not at disposable value since there is no intention to dispose of them. Historical Definition Transactions are recorded in terms of the actual amount at which they occurred in the past. This concept has the advantage of being objective. The amount at which a transaction took place cannot be disputed over, which is also the amount found on the document issued or received during the transaction. Cost Concept Concern Concept

This concept, therefore, eliminates subjectivity associated with valuation in accounting records. Implication Assets and expenses are recorded at the actual amount spent. Revenues are recorded at actual amount received/ receivable. Liabilities are recorded at actual amount borrowed, therefore, payable.

Business Definition

Entity

also

known

as

Accounting

Entity

Concept

The owner and the business are considered as two different persons, distinct from each other. Transactions are recorded from the point of view of the business and not the owner. As such, any amount invested by the owner in the business is considered as a liability by the business. Also, only those transactions that concern the business are recorded.

Implication Personal transactions and private property of the owner are not recorded in the books. Capital and Drawings accounts are kept to record amounts the owner gives to or takes from the business.

Money Definition

Measurement

Concept

Only those transactions that can be expressed in money terms (financial transactions) are recorded in the books. Non-financial Implication Some strengths or benefits of the business may not be reflected in the books since they cannot be expressed in money terms examples are quality of work force and market share. transactions are therefore not recorded.

Accounting Definition

Period

Concept

According to this concept, the lifespan of a business is divided into fixed period of time (months, quarters, half-years or years) for which accounts are prepared. In most cases an accounting period is a year. Note that the accounting year need not be the same as the calendar year. For example, the accounting year for business X can be from 1 June to 31 May, for business B from 1 September to 31 August or for business C from 1 April to 31 March. Implication Accounts of the business are closed at a specific date every year and final accounts are prepared (profits/ losses calculated)

Accruals Definition

Concept

and

the

Matching

Principle

According to the Accruals concept, when calculating the profit of a given period, revenues earned in that period need to be matched against expenses incurred for that same period. This is done irrespective of amount received as revenue or amount paid for the expenses. According to the matching principle, when calculating profit, revenues need to be matched against those expenses incurred to earn the revenues. Implication Adjustment are made in accounts for accrued and prepaid items so that accounts reflect revenue earned (not amount received) and expenses incurred (not amount paid for).

Prudence Definition

Concept

also

known

as

Conservatism

This concept prevents the anticipation of future profits before they are realised but requires to make provisions for losses as soon as they are recognised. Therefore, according to this concept, assets and revenue are not overstated while liabilities and losses are not understated.

Implication Inventory of goods are valued at the lower of cost and net realisable value. Provisions for doubtful debts are made for potential loss in amount owed by credit customers. Materiality Definition According to this concept, when recording transactions, the accountant should consider whether disclosure and non-disclosure of such transaction will affect the decisions of persons reading the accounts. Also, the accountant should consider whether the benefits obtained from the particular treatment to a transaction is worth the effort put to it. A classical example here would be the way an accountant will treat a stapler costing $2 in the accounts. Though this item is bought by a business and will be used for several years, it does not have significant value. Implication Some items (stapler, paper clips etc) are not considered non-current assets though they may be used by the business for a long period of time. Rather, their costs are written off at one against profit in the period they are bought. Consistency Definition All similar items need to be given the same accounting treatment in the same accounting period and from one period to another. Unless there is a valid reason, no changes are allowed in the accounting policy chosen. This concept especially prevents accountants from manipulating the results of a business by simply changing the accounting policies Implication The same depreciation method is applied for similar items in the same period and from one period to another. Dual Definition Aspect Concept Concept Concept

This concept takes into account the two aspects of a accounting represented on one side by the assets of the business and on the other by the claims against those assets. This Assets Implication Transactions are recorded using the double entry system whereby each transaction has a debit entry and a corresponding credit entry.
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Documentary Records (Source Documents) Transactions are recorded by accountants and their subordinates. However, these persons are not those who are directly involved in the transaction. Besides, the accounting departments work with facts; therefore, to record a transaction, proof of such transactions are required. Such proofs are in the form of documents which are received and/or issued by the business upon the occurrence of a transaction. Below is a list of the most common documents used as source documents for recording transactions.

Invoice An invoice is a document that the seller gives to the buyer to inform the latter the amount payable for goods or services supplied to him. The invoice contains details of the seller, the buyer, the goods sold - quantity, price, discount, taxes, net amount payable and terms of payments. From the point of view of a business, invoices can be differentiated as Sales Invoice and Purchases Invoice. A sales invoice is one which the business prepares (in duplicate or triplicate) and issues (one copy) to its customers. The business here is the seller. Total sales from sales invoice is entered in the Sales Journal. A purchases invoice is one which the business receives from its suppliers when goods are bought from them. The business here is the buyer. Total purchases from purchases invoice is entered in the Purchases Journal.

Debit Note A business may return goods bought to its suppliers. There are various reasons for that such as goods received were of the wrong specification, were damaged, were supplied in excess etc. In

that case the business may return the goods to the supplier. Such returns are termed as Returns Outwards or Purchases Returns. When goods are returned to a supplier, it means the business owes that supplier less (that is original amount less amount of goods returned). Therefore, the business will decrease the amount owed to the supplier by a "Debit Entry" in the supplier's account. At the same time, the business will send with the goods returned a Debit Note to inform the supplier that his/ her account has been decreased (in this case debited) by the amount of goods returned. The amount on the debit note is recorded in the Purchases Returns Journal. Credit Note As said earlier, a business may return goods to its suppliers. It is also true to say that customers may return goods to the business and that too for similar reasons discussed above. Returns of goods by a customer to the business are termed as Returns Inwards or Sales Returns. In such cases, the business has to decrease the amount owed by the customer - this is done by a "Credit Entry" in the customer's account. At the same, a Credit note is issued to the customer to acknowledge that goods were received as return from him and that his account has been decreased (in this case credited) by the amount of goods returned. The Cheque A cheque is an advice given to a person (known as the payee) whom we have to pay. He will present this document at a specific bank (where we hold an account) in order to get paid. This is a safe way of effecting payments. We do not have to deal with large amount cash when we run the risk of being robbed. A payment by cheque decreases the balance of our bank account. It is recorded as a "Credit Entry" in the bank column of the Cash Book. However, given that it is taken away by the payee, the cheque itself cannot be used as a source document. But, while drawing a cheque, information is recorded on the piece of paper that remains in the cheque book after the cheque is detached for payment. This piece of paper is called the cheque counterfoil and is used as source document to record payment by cheque. Receipt amount on the credit note is entered in the Sales Returns Journal.

A receipt is a document issued when money (or any other form of payment) is received from someone. It is used as a proof of payment by the person who pays. The counterfoil of the receipt book or the duplicate copy of the receipt held by the business is used as source document to record receipt of money. Receipt of cash is recorded on the "Debit Side" of the Cash Column of the Cash Book while receipt of cheque is recorded on the "Debit Side" of the Bank Column of the Cash Book. Similaly, a business also receives a receipt when money/ cash is paid to another person. This receipt is used a source document to record cash payment which is recorded on the "Credit Side" of the Cash Column of the Cash Book. Statement of Account At the end of each month a Statement of Account is sent to each credit customer who owes the business money. This document is, in fact, a summary of the customer's account from the books of the business. Its purpose is to allow the customer to match our records with his records and if there is any discrepancy, deal with them as soon as possible.
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Capital Expenditure and Revenue Expenditure Businesses usually incur expenditure. Some of the expenditure brings economic benefits to the businesses for a short period of time (within the financial year) while others benefit the business over a long period of time. As such, expenditures are classified under different categories and are accounted for differently.

Capital Expenditure:
These are expenditure incurred in acquiring non-current assets or in making extension to existing non-current assets. Capital expenditure increases the earning capacity of a business. Businesses benefit from such type of expenditure over a long period of time. For example, a delivery vehicle can be used for over 5 years to deliver goods to customers. Computers may easily be used for 3 or 4 years. A building may be used for over 20 years. For the above reasons, capital expenditure are entered as non-current assets in the balance sheet. The cost of non-current assets is charged against profit over the years the assets can used and benefits derived. Such process is called provision for depreciation.

Revenue Expenditure:
These are expenditure incurred for the day to day running of the business. Though they do not increase the earning capacity of the business but they are essential in maintaining it. Revenue expenditure benefits the business only in the period to which they relate. For example, rent is paid monthly, so the rent paid in January only gives the possibility to the business to use a rented property in January only. Similarly, rates and license fees for a given year gives right to the business to be operational only during that year. Other examples of revenue expenditure include repairs to non-current assets, electricity and water charges, telephone expenses, vehicle expenses, fuel etc. Purchase of goods for resale is also classified as revenue expenditure. Revenue expenditure are treated as expenses in the income statement for the period to which they relate.
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Balance Sheet
A Balance Sheet is a statement that shows the financial position of a business at a given date. A Balance Sheet, unlike an Income Statement is not prepared "for a given period" but "at a given date". This is because the Balance Sheet changes after each and every transaction.

Financial Position What the business has Asset How are the assets financed : Liabilities Therefore, Assets = Equity + Liabilities The above equation is called the accounting equation. So, the Balance Sheet applies the accounting equation (1) By the owner Capital / Equity (2) By other persons (Individuals, Suppliers, Banks etc)

Assets

Non-Current Assets

To be classified as a non-current asset an item has to satisfy all of the following criteria: - Is Bought used to for be a used in long period Has the of business, therefore time (usually more significant not than for one resale year) value Assets:

Examples of Non-Current Land and building, Fixtures and Fittings, Equipment, Motor Vehicles

Current Assets
These are the assets of a business that are easily convertible into cash within the normal operating cycle, which is within the accounting year. Current Assets are often referred to as Liquid Assets and are listed in the Balance Sheet according to their order of liquidity - usually starting with the least liquid and ending with the most liquid.

Liabilities

Non-Current Liabilities
These are debts/ obligations/ amount owed by the business but that are repayable after more than one year. An example of non-current liabilities is loan.

Current Liabilities
These are short term debts; that is debts/ obligations that will be paid within one financial year. In other words, these will be paid before the next balance sheet date.

Examples of current liabilities are bank overdraft, amount owed to suppliers (trade payables) and amount owed for expenses (other payables).

Owner's Equity also known as Capital


Owner's Equity refers to the total value of the resources the owner invested in the business. It is also defined as the amount by which the owner is financing the business. It is expected that, in case he wants to cease business, the owner will recover his investment in addition to the profits earned by the business. Therefore, capital/ owner's equity is often considered as the amount that the business owes its owner. However, Net owner's equity does not remain fixed. It changes. Profit

Net profit belongs to the owner. It is the reason why the owner has started business. Therefore, it is added to the owner's equity. On the other hand, a loss is deducted from owner's equity. Drawings This is the amount (in cash and in kind) that the owner has taken from the business for his private use. It is deducted from owner's equity.

Format of Balance Sheet for a sole trader

Name of Owner or Name of Business


Balance Sheet at 31 December 20XX
Non-current (Fixed) assets Land and buildings Fixtures and fittings Office equipment Motor vehicles Current assets Inventory (Stock) Trade receivables (Debtors) Less Provision for doubtful debts Other receivables (Prepayments) Other receivables (Accrued income) Cash equivalents (Bank) Cash

Cost $ 200 000 25 000 12 000 52 000 289 000

Aggregate Depreciation $ 25 000 7 500 2 400 10 400 45 300 18 900

Net Book Value $ 175 000 17 500 9 600 41 600 243 700

7 500 236

7 264 1 236 150 2 550 890 30 990

Less: Current liabilities Trade payables (Creditors) Other payables (Accruals) Prepaid income

5 960 240 250

6 450 24 540 268 240

Net current assets (Working capital)


Less: Non-current liabilities (Long term liabilities) Loan

50 000 218 240

Financed by Equity (Capital) Opening balance Add Profit for the year (Net profit)/ Less Loss Less Drawings

200 000 22 540 222 540 4 300

218 240

Balance Sheets of other types of business organisations:


Basically, balance sheets of all types of business organisations similar. They are prepared using the same principal. What will differ is the financing part. Companies: Financing part for companies shows amount of share capital, reserves and retained profits. Partnerships: For partnerships, the financing part shows the closing balances of partners' capital and current accounts.

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Profitability Ratios:
Consider the following example:
Year 1 ($) 100 75 25 Year 2 ($) 150 120 30

Revenue (Revenue) Cost of sales Gross profit

Gross profit to sales (Gross profit margin) Shows the amount of profit made on each dollar of sales. Also indicates the percentage of sales that is available to pay for expenses and to retain as profit.

Gross Profit Revenue

x 100

Gross profit margin


Year 1 Year 2

$25 x 100 $100 = 25%


Can also be expressed as
2 5 1 0 0 1 = 4 30 150 =

$30 $150
1 5

x 100 = 30%

Can also be expressed as

Gross profit to cost of sales (Mark up) Shows the gross profit as a percentage of cost of sales. Also indicates how much profit is added to every dollar of the cost of goods sold.

Gross Profit Cost of sales

x 100

Markup on cost

Year 1

Year 2

$25 $75

x 100 = 33 .3 %
25 75 = 1 3

$30 $120

x 100 = 25%
30 120 = 1 4

Can also be expressed as

Can also be expressed as

Note that in year 2, despite that profit has increased (from $25 in year 1 to $30 in year 2), margin is less (20% compared to 25% in year 1). Markup also is less (25% as compared to 33.3% in year 1). Possible reasons for these differences are listed in the grid below: Increase in margin and markup
1. A decrease in purchase price not passed on to customers 2. Trade discount received for bulk purchase 3. An increase in selling price 4. The business no longer allows trade discount 5. Overvaluing closing inventory 6. Undervaluing opening inventory

Decrease in margin and markup


1. Increase in purchase price of goods not passed on to customers 2. Buying in smaller quantities, therefore, no longer enjoying trade discount 3. Selling price cut down 4. Overvaluing opening inventory 5. Undervaluing closing inventory

Relationship between margin and markup: As can be seen above, gross profit margin and markup are related. This is because they are calculated by the same figures. Remember that gross profit = Revenue cost of sales. Therefore, Gross profit margin can be expressed as

Revenue Cost of sales Revenue

x 100

and Markup can be expressed as

Revenue Cost of sales Cost of sales

x 100

As such, when one is given, the other can be easily calculated. Simply apply one of the following rules:

1. Gross Profit Margin =

Markup 1 + Markup

2. Markup =

Gross Profit Margin 1 Gross Profit Margin

The above rules apply for both fractions and percentage. Let us try (we use the example given above)

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Net profit to sales (Net profit margin) Shows the amount of net profit earned from each dollar of sales made, after all expenses have been paid.

Net Profit Revenue

x 100

Like other ratios, net profit margin also may increase or decrease. Increase in margin and markup
1. Increase gross profit margin 2. Reduce expenses

Decrease in margin and markup


1. Decrease gross profit margin 2. Increase expenses

Given net profit = gross profit expenses, we can also calculate the Expenses to sales ratio (also known as expenses to turnover ratio). This shows the amount from each dollar of sales that is used to pay for expenses.

Expenses Revenue

x 100

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