When taking a look at an income statement, one of the first things we want to focus on are our net sales. Net sales mean net of any returns, net of any allowances, but it’s really the main source of money that we either receive for our goods or our services. That’s why we’re in business. When we take a look at our net sales, we want to compare that or reduce fund [that 00:01:54] the cost of sales. Now, in a manufacturing environment, this cost of sales is pretty identifiable. We’re looking at three basic components of direct materials, direct labor, and manufacturing overhead. Now, the cost of goods sold is one of the critical things that we really need to take a look at.
Often I hear financial executives from small to mid-size, even large businesses make comments that, “Wow, I’m bringing in five million dollars annually,” or, “I’m bringing in ten million dollars annually, however, we always seem to be struggling for cash flow,” or, “We’re making a loss. We’re not making money, or our profits are not large enough.” One of the possible reasons for that could be the fact that we haven’t priced our goods at a high enough profit margin to at least cover our cost of sales and our fixed cost. That’s what the gross margin is going to represent. It takes a look at our net sales. We reduce our net sales by a gross margin. I’m sorry, by our cost of sales, which would give us our gross margin. When we take a look at our gross margins, it’s the amount left over for us in order to pay our fixed costs and gives us an idea of what type of profit that we can make from our sales.
In order to calculate gross margins, we’re going to take a look at our total gross margins, meaning our net sales less our cost of sales, that’s going to give us our gross margin. We divide that by our total revenue, that is going to give us a gross margin. I spoke about fixed costs earlier, and when we talk about fixed costs, some of it is included in our selling, general, and administrative expenses. [inaudible 00:04:00] We have those costs that really are non-cash type of expenditures. We have to pay attention to those when we’re looking at our net income. What we mean by non-cash, these are things such as depreciation and amortization.
Depreciation occurs when we purchase a product or a fixed asset and then we take the cost of that fixed asset. Rather than expensing the full cost right away, we spread that cost over its expected useful life of that asset. Therefore, we have an outlay of cash initially, however, on an annual basis, there is no additional outlay of cash for that asset. When we take a look at our sellings, general, and administrative expenses, these are all other expenses, such as our salary, things that are not directly attributable to the actual making of the product, or producing the goods, or producing the services. These are advertisings, things such as promotions, travel, but these are all other types of expenses that we have to deduct from our gross income in order to get to our ultimate goal here, to find out what is our profit.
Now the operating income. We talked about many of the components already, but it’s our sales less our operating expenses. It’s often referred to ask EBIT, which is income before interest and taxes. One of the reasons we break out interest and taxes is because it’s [really 00:05:36] non-operating interest [usually 00:05:39] occurs from financing. Unless we’re in business to finance other businesses, that interest is not a part of our normal day-to-day operation. Now, the operating margin is calculated by using the operating income as a percentage of gross revenues, and we divide that by the net income. This operating margin is really used to gauge how efficient our company is. It’s a thing that’s used traditionally across industries.
You can use this operating margin in order to measure your efficiency against another company that may be producing more money or more gross or net sales. However, because we’re looking at the results on a percentage basis, we can really measure how efficient our operation is compared to another operation. For the dividend and the interest income, again, these are components of our operating or our net income that you’ll find traditionally on the income statement, but these items, they are not a part of our normal day-to-day operations. Now, I spoke earlier about income taxes, and we’re going to talk a little bit more in depth about income taxes right now. Our income taxes vary from company to company. It’s based upon what our individual income level is, based upon what the individual state tax rate is, as well as sometimes your city tax rates will differ. This will vary depending [inaudible 00:07:21] the organization, however, it is a factor in determining our net income, because we all have to pay taxes.
We break out our income before taxes, and then we take a look at our income after taxes, but before our extraordinary gain or loss. We’re in business to usually provide a certain product or provide multiple products and services, but when we have something out of the ordinary, we need to take a look at that because in order to gauge how well your company is doing, you want to look at it over a period of time. You want to look at the trend, and if you have things that are non-occurring included in that trend, it gives you a false outlook on how well your company has done in the past, or either trying to determine how well or how profitable your company can be going forward, for instance, elections happened or presidential elections happen once every four years.
If you’re looking at numbers during a presidential year and your gross revenue or net revenue has really benefited from the fact that there was a presidential election, over the next three years, you really can’t expect to gross that same amount of revenue that you did during that presidential election, because it happens every three years. That’s why when we take a look at our extraordinary gain and losses, we separate those items out so that we can really figure out what it is we’re making or what it is we are projected to make from our operations. Net income is all income less expenses, including those extraordinary items if you’re trying to look at your net income for that specific year.