MSE IPF Blog - An Investor Education Initiative by MSE Investor Protection Fund
How to interpret profit numbers in the Annual Reports
You can refer to it as the Income Statement or the Profit & Loss Account in an annual report. It means one and the same. Unlike the balance sheet, which is viewed at a point of time, the income statement is viewed over a period of time. This period can be one quarter or one year as is the norm. Remember, accounting is done on an accrual basis that means you book all incomes and expenses when they are accrued; not exactly when they are actually paid or received. When all the accrued incomes and expenses for the financial period accounted for, the net result that you have is the income statement or the P&L account. The P&L account is critical to understand whether the business under consideration is profitable or not and this gives rise to a number of other analytical ratios.
What is the purpose of a Profit & Loss Account (Income Statement)?
The income statement shows the profitability of any business over a specific period. It can cover any period of time, but is most commonly produced monthly, quarterly or annually. Indian companies report their profit statements on a quarterly basis and on an annual basis as per the extant regulations. What is the purpose of a profit & loss account? A profit and loss report is a useful tool for monitoring business activity. It highlights where their business is succeeding and where it is struggling. Equity investors use the financial statements to gauge the financial health of a potential investment, or to see what kind of return they are getting on an existing investment. Bond investors check the income statements to ensure that the company has the ability to generate cash flows to repay the debt. Potential acquirers use the income statement to gauge whether the profits of a company are adequate to justify an acquisition or a merger with the target company. In short, this income statement is the starting point to understand the nuances of a company’s performance.
Breaking up the P&L Account into revenues and expenses
In general, the profit and loss report is split into 2 sections; the inflows represented by the revenues and the outflows represented by the expenses. Revenues include the inflows from the primary business activities (i.e. sale of products and services), any revenue from secondary activities (e.g. bank interest) and any other financial gains. Revenues can also be extraordinary like a recovery of a loan or a one-time gain from the sale of a business division.
One the other hand, expenses detail all outflows on account of the primary activities of the company (e.g. material and labour costs), any administrative costs like salaries, wages, rent etc and the interest cost on borrowings. The depreciation is not exactly a cash outflow but it is still shown as an expense in the P&L account so that the company can use the tax shields from such expenses to fund their future asset renewals.
Difference between operating and non-operating items in the P&L account
The most important part of revenue section of your profit and loss report is total sales. Secondary revenue and other income can be unpredictable, so to grow your business you should focus on your primary sales revenue. Operating revenues and operating expenses refer to the core business of the company and this is the most important metrics as it represents the core that is sustainable. How much sales have risen or fallen since your previous profit and loss report and the breakeven level of sales are a lot more important from the core business point of view.
Operating profits matter more than non-operating profits as they can be harder to bring down. On the other hand, one can give too much credence to the non-operating flows either inflows or outflows. For example profits or losses on investments or sale of assets are not part of the regular business. Such items should be excluded from your definition of sustainable revenues. Let us now turn to the core profit flows of the business.
Different types of profits and when to apply these measures
The P&L account itself is a summation of different kinds of profits with each having a different interpretation and application. Let us look at some key profitability metrics.
Gross profit = Revenues - cost of goods sold
Gross profits represent the difference between total sales and the cost of producing the goods or services you sell. It is a barometer of the core production or service activity and becomes a guide to pricing the product or service appropriately and also gives you an idea of how much leeway the business when it comes to pricing. The gross profit margin (GPM) is normally more relevant than the absolute number as it gives a relative analytical picture.
Operating profit = Gross profit - operating expenses
Cost of goods sold refers to the costs that are directly attributable to the output. But there are other fixed costs like rent, salaries, office expenses, maintenance costs and depreciation which are also business expenses. When you deduct these other operating expenses from Gross Profit you get the Operating profit or (EBIT). Here again, the OPM has a lot more importance and impact than the absolute number.
Net profit = Operating profit – interest - taxes
This is called the “bottom line” because that is what shareholders earn after paying out all costs of the business. Some of the most important ratios like the net profit margins; ROE and ROA are based on this Net Profit only.
An understanding of the subdivision of profits is the key to understanding where the profit is coming from and what should be the analytical strategy in response.