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Colour Accounting refresher – Income and Net Profit Margin

08/05/2019

Insights from Justin Martin, Colour Accounting Facilitator:

Income

Income is defined as a value-generating activity, a verb concept.

Income is a source of funds for a business (yellow in Colour Accounting).

Examples of income include: revenue from the sale of goods or services, interest income, dividend income, and rent received.

It is important to distinguish between the receipt of cash and the recognition of income. Income can be recognised before, at the same time, or after the cash is received.

The three timing scenarios are as follows:

  • Same time: cash sale – income is earned at the same time as the cash is received
  • Before: accrued sale – income earned first, then cash received later. For example, when goods are sold on credit to a customer and they pay the invoice at a later date
  • After: unearned (deferred) income – cash is received first, then income earned later. For example when a customer buys a gift voucher which is spent purchasing goods at a later date.

One ratio that helps us understand how efficient a business is in generating a profit for the owners is the Net Profit Margin. This measures the percentage of sales income that is retained in the business for the owner.

Net Profit Margin

Also known as the Return on Sales percentage. The formula is:

Net Profit Before Tax for the period divided by Total Sales

 

(Net Profit Before Tax =
Total income – Direct costs – Indirect costs)

A high percentage indicates greater profitability for every dollar of sales, which can be achieved through cost savings (reduce direct costs and operating expenses), increasing sales, or a combination of both.

Gaining an understanding of industry norms for net profit margin (if available), comparing with prior year actual results, and comparing with current year budget/forecast are all methods that can be used to help an owner determine how well the business’s margin is tracking.


Check out upcoming Colour Accounting workshop dates here.