Financial Statement Review and Ratio Analysis(#2 in series)
Q: To arrive at the gross margin and SG&A%, why did you add depreciation / amortization in the Gross Margin computation and subtract depreciation / amortization in the SG&A% computation?
A: The effect of the non-cash charges – depreciation and amortization – is excluded from the calculation of both the Gross Margin and SG&A%.
With respect to computing the Gross Margin, there are two approaches that yield the same result. One is to add depreciation expense to reported Gross Profit since, if depreciation expense is included in Cost of Goods Sold, reported Gross Profit needs to be increased by the amount of depreciation expense in reaching Gross Profit excluding depreciation expense. In the case of Total Coverage, Inc., no depreciation expense was reported as a cost element in Cost of Goods Sold, and so we did not have to add back depreciation expense to the reported Gross Profit.
The other approach is to add all costs reported as cost of goods sold expenses, except for depreciation expense, and subtract this total from sales to arrive at Gross Profit excluding depreciation expenses. Once we have this amount, we divide by Sales to get the Gross Margin. This is essentially the same as adding depreciation expense to Gross Profit and dividing by Sales.
With respect to SG&A%, we subtract depreciation expense from Total Operating Expenses to get SG&A excluding depreciation expense. Once we have adjusted Operating Profit, we divide by Sales to get SG&A%.
Course overview: Financial Statement Review and Ratio Analysis