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Reading a profit and loss statement.

[check] This checklist is designed to help you read and understand a profit and loss statement. It is intended as a guide, not as a replacement for full accounting support and interpretation.

Definition

A profit and loss statement shows the summarised trading activity of a company (or other organisation) during a stated period and reflects all accounting entries of a profit and loss nature during that time. Profit and loss statements are frequently prepared for internal management purposes.

Companies (and certain other organisations) must publish profit and loss statements. The profit and loss statements of companies must, by law, comply with one of four formats. One of them is in more common use and is the one used in the example. Published profit and loss statements are almost always accompanied by detailed notes and it is permissible to include some of the information in the notes rather than in the statement itself. Figures for the corresponding previous period are also shown.

A small company (as defined by the Companies Act and with certain exceptions) need not publish a profit and loss statement. A medium-sized company (as defined by the Companies Act and with certain exceptions) is permitted to show less information in its published profit and loss statement.

Advantages of understanding a profit and loss statement

These include:

* gaining a meaningful indication of the financial performance of the company for the period covered

* gaining a thorough understanding of past performance, essential when drawing up future budgets and formulating plans

* gaining a better understanding of the other parts of the accounts and reports.

Action checklist

1. Look at the trends

In a published profit and loss statement, figures for the current and previous year are given. Key figures for additional periods may be elsewhere in the accounts. It is always worth looking at the trends revealed. The example shows that turnover is up and profit is down, indicating a worsening in margins.

2. Look at the profit/turnover ratio

Profit on ordinary activities expressed as a percentage of turnover is generally considered to be one of the key ratios. Sometimes profit before tax is used and sometimes profit after tax. The trend in the ratios may be particularly significant.

In the example it is 9.8% if profit before tax is used - 98.2/999.9 For the previous year it is 16.9% - 155.8/923.6

If profit after tax is used, it is 7.7% - 77.1/999.9 and 13.5% - 124.4/923.6 for the previous year.

3. Look at the cost of sales percentage

Reveals the gross margin, which is the difference between turnover (or income) and the cost of goods manufactured or purchased.

It is particularly useful to look at the trend in the cost of sales percentage. Of course, like all the other ratios, consideration should be given to the reasons for the figures and the reasons for the changes. For example, a worsening in the ratio, although apparently unwelcome, may be the result of a management decision to boost sales by cutting prices and part of a plan to increase the overall net profit.

In the example the cost of sales percentage is 44.4% - 444.4/999.9

In the previous period it was 35.1% - 324.2/923.6 so the gross profit margin has deteriorated.

4. Consider the significance of any extraordinary items

Extraordinary (or exceptional) income or expenditure arises in ways other than normal trading. For example, it might in some circumstances include the sale of assets, tax rebates, redundancy payments or acquisitions. It is therefore not expected to recur and would distort the profit and loss statement if grouped with the figures that do result from normal trading.

Details of extraordinary income and expenditure are always given in the notes and these notes should be examined closely. You will need to assess the significance of the figures. In the example extraordinary income for 2000 is less than 2% of normal turnover, but 18.3% of profit on ordinary activities before tax.

5. Read the notes to the financial statement

It is almost certain that detailed notes will accompany a published profit and loss statement. They may well include further information in the following areas:

* A breakdown of turnover showing sales by region and type of product.

* Details of any extraordinary income and extraordinary charges.

* Details of interest paid and interest received.

* Details of the tax charge.

* Details of dividends paid and proposed.

* Details of employee costs, repairs and renewals, the depreciation charge and the basis of its calculation.

6. Consider the profit and loss statement in conjunction with the rest of the accounts

Some useful ratios may be obtained by comparing figures from the profit and loss statement with figures from the balance sheet and elsewhere. One such ratio is Return on Capital Employed (ROCE). If the example is used and if capital employed is 500,000 [pounds sterling], ROCE is 15.4% - 77.1/500.0

This uses 'Profit on ordinary activities after taxation', though sometimes a different definition of profit may be used.

7. Be aware of the accounting policies

Many of the accounting entries leading to the profit and loss statement are matters of clear fact in that money has been received or spent. However, some of them may depend on judgement and the accounting policies used. Areas most likely to be affected include depreciation, bad debts, reserves and accounting for long term contracts. Markedly different results may be obtained if different accounting policies are used.

In the case of a published profit and loss statement the main accounting policies will be stated in the notes. So too will be any change in the accounting policy and the effect of any change.

8. Look at interest and dividends

These are the rewards for providing finance for a company. Dividends are paid to the owners (the shareholders) and in most cases the amount can vary from year to year; it can be NIL. Interest is paid to banks and other providers of loans. Interest may be receivable as well as payable, if the company does not borrow.

Interest and dividends are important and both will be shown in a published profit and loss statement. Interest contributes to the profit or loss before tax. Dividends are an appropriation of profit and are shown after the figure for 'profit before tax'. In order to fully appreciate the figures it is necessary to study them in conjunction with the balance sheet and the notes. A relatively high interest payable figure may be cause for concern. It may indicate that the company is overtrading and it may turn an otherwise acceptable profit into a disappointing profit, or even into a loss.

Do's and don'ts when Reading a Profit and Loss Statement

Do

* Look at the statement in conjunction with the balance sheet and the other financial statements.

Don't

* Miss the significance of a change in accounting policy. For example, a change from 10% pa to 15% pa in writing down a 1,000,000 [pounds sterling] fixed asset will reduce the declared annual profit by 50,000 [pounds sterling].

* Miss the significance of a change in the accounting period. For example, a 15-month period to 28th February will include two Christmases.

* Forget that there may be an explanation for odd-looking figures and ratios.

Useful reading

Meaning of company accounts 8th ed, Walter Reid and D R Myddleton Aldershot, Gower, 2005

Bookkeeping and accounting in a week 3rd ed, Roger Mason Chartered Management Institute (CMI business in a week series) London, Hodder and Stoughton, 2003

Analysing financial statements in a week, Roger Mason Chartered Management Institute (CMI business in a week series) London, Hodder and Stoughton, 2002

Accounts demystified : how to understand and use company accounts, rev ed, Anthony Rice Institute of Management London: Prentice Hall, 2000
ACME LTD

Consolidated Profit and Loss Account for the Year to 31st December 2000

 Year to
 31-12-00
 [pounds sterling]000

Turnover 999.9

Cost of sales (444.4)

Gross profit 555.5

Distribution costs (161.8)

Administrative expenses (322.2)

Other operating income 21.6

Income from shares in group undertakings 93.1

Income from participating interests 7.2

Income from interests in associated undertakings 4.9

Income from other participating interests 3.8

Income from other fixed asset investments 12.4

Other interest receivable and similar income 7.6

Amounts written off investments (3.0)

Interest payable and similar charges (27.8)

Profit on ordinary activities before taxation 98.2

Tax on profit on ordinary activities (21.1)
Profit on ordinary activities after taxation 77.1

Minority interests (13.4)
 63.7

Extraordinary income 8.0

Extraordinary charges 4.0)

Extraordinary profit 14.0

Tax on extraordinary profit (2.0)

Minority interests (1.9)

Other taxes not shown under the above items (0.6)

Profit for the year 73.2

Dividends paid and proposed (28.0)

Retained profit for the period 45.2

 Year to
 31-12-99
 [pounds sterling]000

Turnover 923.6

Cost of sales (324.2)

Gross profit 599.4

Distribution costs (138.7)

Administrative expenses (299.0)

Other operating income 31.8

Income from shares in group undertakings 193.5

Income from participating interests 6.6

Income from interests in associated undertakings 5.0

Income from other participating interests 2.1

Income from other fixed asset investments 10.8

Other interest receivable and similar income 7.2

Amounts written off investments (3.0)

Interest payable and similar charges (66.4)

Profit on ordinary activities before taxation 155.8

Tax on profit on ordinary activities (31.4)
Profit on ordinary activities after taxation 124.4

Minority interests (21.6)
 102.8

Extraordinary income 16.1

Extraordinary charges (6.1)

Extraordinary profit 10.0

Tax on extraordinary profit (1.9)

Minority interests (1.7)

Other taxes not shown under the above items (0.6)

Profit for the year 108.6

Dividends paid and proposed (20.0)

Retained profit for the period 88.6
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Title Annotation:Checklist 183
Publication:Chartered Management Institute: Checklists: Managing Information and Finance
Geographic Code:4EUUK
Date:Oct 1, 2005
Words:1662
Previous Article:Managing working capital.
Next Article:Discounted cash flow.
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