Profit & Loss/Income Statement:Reading& Interpreting

Abstract

Financial statements are a structured presentation of financial information about the firm over/at a point of time in standard formats and consistent terms. Normally there are three types of statements prepared by the accounts branch of a firm

Balance SheetIncome/Profit & Loss StatementCash Flow Statement

Though inter-related and using the same information, all three statements have different formats with different emphasis. Thus the Balance Sheet depicts the liquidity position of the firm, the Income statement shows its Profitability position. On the other hand, Cash Flow Statement reveals its Solvency position.

In other words, the Profit & Loss account measures financial performance over the year whilst the Balance Sheet states the financial position as at the year-end. Cash Flow statement explains the sources of funds generation and heads of their spending.

This article explains what is the Profit & Loss Statement, how it is presented, how to read it, and what are its limitations

What is a Profit & Loss Statement

All year round a business organisation is manufacturing goods or purchasing them for resale for which it incurs costs. Running the firm and marketing/selling the finished goods also entail costs. These goods are sold at profit or loss and all these transactions are recorded in different accounts. At the end of an accounting year, the firm uses these accounts, makes a statement to know how much it spent and how much it earned. This statement is known as Profit & Loss or Income Statement

Why P & L Statement is Important?

Balance Sheet shows the liquidity position of the firm at a particular date-how many assets you have? P&L Statement shows how you are using those assets. Depicts the profitability/loss position of the business concern over a given period of time-monthly/yearly

It not only explains the sources of income and how that income is spent but also traces the nature of costs within one year-fixed cost, variable costs, and the break even point. These are extremely necessary information for cost reduction and income maximisation

The Profit & Loss Statement- Who needs it and why?

Although preparation and publication of financial statements is a legal requirement, it has multiple uses. Its multiple stakeholders want to know 

Owners: to know how the business is going, how much profit they are earning, who is getting what out of this profit margin, etc. What is happening to my equity?Management: to keep track of the business and carry out timely corrective measures. How is our firm doing? Directors need to control the overall performance of the company and make strategic financing and investment decisions. Middle management needs feedback on whether they are meeting their financial targets.Lenders: to know whether you are worth lending money or not.Competitors: to know where you stand vis a vis them. And if you are a success, then naturally they will like to know the secrets of your success for obvious reasons. Why you are more successful?Government: to tax more or to give generous allowances to the industry as a whole if it realises the importance of the industry for the realisation of its overall national vision.Employees: to know whether we are getting an equitable share in the cake we made. Are our pension contributions safe or being squandered on frivolous heads? What will happen to our bonuses? To our pension funds?Suppliers: to assess the creditworthiness of potential and existing customers to make a decision whether to sell goods and services to you or not and the amount and period of credit allowed. No one would like to supply goods to a firm that is likely to sink under its debt burden.Customers: to minimize the risk of their supplies drying up and disrupting their own output. Firms entering a joint venture will also need mutual reassurance.Civil Society Organisations/Media: to know what is happening to the business as it will affect the working of the national economy and in turn, will affect the quality of life of the citizens.Shareholders: to know your firm’s performance to decide whether to purchase more shares or sell the present ones?Firms entering a joint venture will also need mutual reassurance.

How the P&L Statement Prepared?

There are 08 steps involved in the preparation of a P&L statement from the accounts

Estimate all the revenues from business activities-sale of goods/sale of assets etc during the year under reviewSubtract manufacturing/ administration/ selling costs from Estimates andArrive at EBITDA-earnings before interest, taxes, depreciation, and amortisationSubtract depreciation from EBITDA andArrive at EBIT-earnings before interest, taxesSubtract interest from EBIT and arrive at PBT-profit before taxesSubtract taxes from PBT and arrive at PAT-profit after taxSubtract dividends from PAT and arrive at RE-retained earnings

Format of P &L Statement

Four different Formats prescribed by The Companies Act but the following Format (known as Format 1), comprising four stages, is the most popular

Stage 1 = manufacturing – shows the cost of goods manufacturedStage 2 = Trading – this shows the gross profit earned by matching the income against the cost of salesStage 3 = Profit and loss – the overhead expenses of running the business are deducted from the gross profit to arrive at the net profitStage 4 = Appropriation – how the profit is appropriated

Format 2 contains more information in the main part of the P&L but Format 1shows the extra details in notes. Thus, there is very little difference between Formats 1 and 2.

Formats 3 and 4 are rarely seen but they both use a horizontal presentation that reflects double entry bookkeeping.

Application of Conventions (UK GAAP) in P&L Statement

As per convention,

Realization Principle: Income is counted when delivery of goods/services takes place, not at time cash received.Accrual Principle: Expenses go into the profit and loss account when they relate to the period covered by the statement – this is the case even if they have not yet been paidMatching Principle: Expenses incurred during this period must relate to goods and services sold and reflected in the same statement

P & L Statement is not Cash Statement

The profit and loss account is not a summary of all cash flowing in and out of the business in one year. Some cash transactions are meant to purchase fixed assets which are reflected in the Balance Sheet. Only their depreciation expense is shown in the Profit & Loss Account, not the entire cash spent on their purchase

Similarly, a long term bank loan will inject a lot of cash but it will be shown as a long term liability in the Balance Sheet, not a profit in the P & L Statement

How to Treat Carryover Stocks

Normally no firm is successful in selling all the stocks it produced during one year within the same year. These leftover goods are shown as Closing Stock in the P & L statement of the current year and become the Opening Stock for the next years P & L statement

According to the matching principle, only that revenue from the sale of goods is reflected in the P & L Statement which was received during the year from the sale of goods, not the total goods produced. Therefore the two stock figures represent the following;

Opening stock = expense brought forward from a previous period to present one

Closing stock = expense to take from this period and carry

Depreciation

Fixed assets are usually bought in one accounting period and the expenditure incurred is recorded in the Balance Sheet for that year. However, a fixed asset keeps on giving benefits to the firm for several years. Thus, we divide the cost we paid for them by the number of years and assume that this fixed asset will cost this much for this year and provide equivalent benefits for that same year. This cost is known as depreciation in the P & L Statement. It is different from Accumulated Depreciation shown in Balance Sheet

In the UK there are two main methods used to calculate depreciation:

The Straight-Line Method: A firm divided the replacement cost of the asset by the number of years it will be used and the resultant number is used to set aside as depreciation for each year-same amount every yearThe Reducing Balance Method: A firm sets aside more as deprecation in first year than second, more in second year than third and so on. Thus each year lesser and lesser amounts are set aside as replacement costs for the asset

Depreciation: HMRC Tax Assessment

While calculating the tax liability of a firm, HMRC ignores a company’s own depreciation charge and substitute their own tax or capital allowances. For most industries and locations there are only 3 rates of tax allowance:

4 % pa based on the original cost of industrial buildings and calculated on a straight-line basis25 % pa on the reducing balance of plant, equipment, fixtures, furnishings, and vehicles with a life not exceeding 25 years6 % pa on the reducing balance of plant and equipment with a life exceeding 25 years

However, HMRC may give special allowances for incentives and / or specific industries

How to Interpret the P&L Statement

Profit and Loss Statement of a firm shows the profitability or otherwise the position of the firm- whether we are earning profits or running into losses. For this purpose, we use ratios. Ratios are the quotient of a number or sum of numbers divided by another numerical value. Ratios tell you the relationship among selected items of the financial statement data. Once calculated, we use the results to compare our performance at three levels

Horizontal Performance: We compare these ratios with past ratios of the firm to assess whether we are improving over time, stagnant, or worsening.Comparative Performance: we compare these ratios with our close competitors to find whether we are doing better or worse or equally as compared to our rivals in the field.Vertical/Positional Performance: we compare these ratios with the industry ratios and find out where do you stand in terms of the overall marketplace. Are we at the bottom in terms of operational efficiency or in the top few? Or just average?

Some of the most important ratios used to interpret the Profit and Loss Statement of a firm in terms of its operational efficiency, customer loyalty, and competitiveness are as follows;

Gross Profit Margin

It is calculated by dividing the difference between the total revenue earned by the sale of goods and services in a year and the total costs incurred on their manufacturing by the total revenue earned i.e.

Revenue-Costs of goods sold/Revenue

It is the first estimate which gives you a bird eye view of whether the goods sold are earning or losing. Any gross profit margin above 35% is considered a good one. Obviously the more the better.

 

Operating Profit Margin

It is arrived at by dividing the earnings left over after subtracting manufacturing as w2ell as the administration and marketing/selling costs from the estimated earnings but before paying interest, taxes, depreciation, and amortisation i.e.

EBITDA/Sale

This is a fair estimate of your real profitability and tells you whether your administrative and marketing costs are normal or they are eating away the bulk of your gross profit. If so, there is a need to check these costs.

 

Net Profit Margin:

This is calculated by dividing the net profit earned  revenue earned from the sale

Net Profit/Sales

Earnings per Share

Net Profit/No of Shares

Compare these with the last five years, with competitors, and with industry#

From the E-book “Finance for Non-finance Managers: A Handbook” by Shahid Hussain Raja, published by Amazon https://www.amazon.com/dp/B07TTNNTC8