Profit & Loss Statement – An important concept in Fundamental Analysis

Know everything about Profit & Loss Statement & its Analysis here. The Income Statement is an important past of Fundamental Analysis which we will discuss here.

Lets have a detailed understanding of Profit & Loss or Income Statement here.

About Profit & Loss Statement & its Analysis

The financial statements broadly include three reports: Statement of Profit and loss, Balance Sheet, and Cash Flow Statement.

Our other article shows how financial statements are crucial for making an investment decision. In case you do not know, financial statements are a record of the organization’s financial activities throughout the year.

With the help of financial statements, we can analyze the current situation of the company and its growth prospects. The financial statements can be thought of from two perspectives that are:

The Maker’s Perspective

The maker of the financial statements is someone who has an in-depth knowledge of accounting and finance.

The maker cannot directly arrive at the financial statements as there is a process that needs to be followed.

Therefore, the maker needs to prepare journals, ledgers, match the bills and receipts, etc.

The basic objective of following the entire process is to make the financial statements that represent the true picture of the company, in the most transparent manner possible.

The User’s Perspective

The user of a financial statement is the person who reads it for various purposes such as investing, analysis, etc.

While the maker of the financial statements is expected to have the in-depth technical knowledge, the user is not expected to have the same.

The user is only expected to have enough knowledge to read and analyze the financial statements properly.

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Introduction to Profit and Loss Statement

In this article, we are going to talk about Profit and loss statement also known as Income Statement.

As the name suggests, this report tells us about the net earnings of the company. A positive value depicts profits, while a negative value depicts losses.

The four major heads in a profit and loss statement are:

• Revenue of the company during the given year
• The expenses incurred by the company for generating the Revenue
• Tax paid during the year and depreciation charged
• The earning per share or EPS

However, before arriving at the list of heads, you need to know about the various columns and headers present in a statement of Profit and loss.

Let us consider a company XYZ that deals with electronics. The below-mentioned table is the XYZ’s statement of Profit and loss

Statement of Profit and loss for the year ended March 31, 2020 (Rs. in crores)

The above table depicts a typical statement of Profit and loss. Let’s take a brief look into all the elements:

Financial Year: On top of every financial statement, you will see the name of the statement along with the financial year.

For instance, in the above table, the phrase Statement of Profit and loss for the year ended March 31, 2020 tells us that the statement is annual and not quarterly along with the financial year i.e., 2020-19.

Unit: In the rightmost corner, we get to see the currency as well as the unit in which the financial statement is made.

For instance, in this case, the currency is Rupees, and the unit is crores. This means that a figure of 20 in the statement will represent 20 crore rupees.

Particulars: They represent the various heads found in the financial statements. For instance, the main heads, including Revenue, expenses, etc. are all found under the particulars section.

Note Number: The amount mentioned in the particulars under various heads is the final amount represent by that head.

In case you want to know more about that head, you can refer to the note number mentioned adjacent to the head.

The note number will help you find important information about that head, using which the maker arrived at the final figure.

Financial Years: The remaining two columns represent the financial years. As per the standard format, the companies are required to represent the data of the latest financial year as well as the previous financial year.

The left column represents the latest financial year, while the right column represents the previous financial year.

For instance, in this case, the latest FY is 2019-20 while the previous FY is 2018-19.

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Particulars of Profit & Loss Statement

To start Analysis of Profit or Loss Statement, it is important to learn about all the details of the same.

Since we have gained the basic information about multiple columns present in a financial statement, let us now discuss the heads in detail.

Lets us dig in detail about each of these particulars.

Revenue in Income Statement Analysis

While reading the annual reports or while talking with the analysts, you must have heard about a term, top line of the company.

Well, the top line of a company is simply the Revenue generated by the company. While reading a profit and loss statement, the first head that you come across is Revenue.

If we look at the above-mentioned table, the first item under Revenue is Sale of Products. This Revenue refers to the amount earned through operational activities.

In this case, our company deals in electronics. Therefore, the amount mentioned under Sale of products depicts that the company sold electronics worth 40,000 crores during the financial year ending March 31, 2020.

The next item represents the Excise duty paid by the company to the government, which is 4000 crores. Therefore, it needs to be deduced from the Sale of Goods.

The amount after adjusting the excise duty represents the Net Sale of Products/Company, which is 36,000 crores.

However, the sale of products is not the only source of Revenue for the company. Since we are dealing with electronics, we provide services for various electronic devices, and the Revenue generated from that comes under the Sale of services.

More from Revenue in Income Statement

In this case, our Revenue from the sale of services is 500 crores, and the Revenue from other operations is 20 crores.

After adjusting all the items, we get the total operating Revenue as: Operating Revenue = Net sale of products + Sale of services + Other operating Revenue

Operating revenue = 36,000 + 500 + 20 = 36,520 crores

Apart from the above-mentioned figures, while reading an actual Profit and Loss statement, you might get to see notes to account as well.

The two major notes to account in case of Revenue can be Revenue from operations and Other Income

Notes to account for Revenue from operations: In this, we find all the details related to the Revenue generated by the company through operational expenses.

As mentioned above, there are three major items found under the Revenue from operations. These include Sale of goods, Sale of services, and other operating Revenue such as Sale of scrap (if any).

The Sale of goods can be of both finished goods as well as stock-in-trade.

Notes to account for Other Income: All the income that is not a part of the main business of the company comes under other income. Some of the most commonly found items under other income can be:

Interest income, Dividend income, Insurance claims, Discount received, Bad Debts recovered, and Sundry Income.

Expenses in Profit & Loss Statement Analysis

After adjusting all the above mentioned items, we received the Revenue for the year ended March 31, 2020, as 37,000 crores. However, this is not the Profit earned by the company.

This is because to receive this Revenue; the company must incur multiple expenses. Now we are going to discuss the expense side of the Statement of Profit and Loss

In general practice, the expenses are classified on the basis of their nature. This method is also known as the cost of sales method.

The above-mentioned table is an extract of the Profit and loss statement to show the expenses under the statement. Let us discuss all the items in detail:

Cost of Goods consumed:

As the name suggests, this item includes the cost of raw material that is required by the company for manufacturing finished goods. In the case of XYZ, the cost of material consumed for the year ended March 31, 2020, was 21,000 crores.

If you observe the expenses side of the statement of Profit and loss, you will observe that cost of material consumed is the biggest expense. This observation holds true in the case of most companies.

Purchase of stock-in-trade and change in inventory:

In simple terms, the purchase of stock in trade is the amount paid for the purchase of finished goods for business purposes. In the case of XYZ, the purchase of Stock in trade for the year ending March 31, 2020, is 2000 crores.

On contrast, change in inventory tells about the cost of manufacturing incurred by the company in previous years.

However, the goods could not be sold in the previous year, and they are sold in the current financial year.

In the case of XYZ, the change in inventory for the year ending March 31, 2020, is (300) crores. This shows that the company produced more goods than it could sell in the year 2019.

Since the goods are not sold in the current year, the company reduces the cost of manufacturing from the current year.

When these goods are sold, this cost is added back by the name, Purchase of stock-in-trade.

The company does this so that the cost of the product gets represented in the year in which it was sold and not in the year in which it was manufactured.

Employee benefits expense:

Every company needs a certain set of employees to perform the operations smoothly. All the expenses directed towards these employees come under employee benefits expense.

This usually includes items such as Salary, wages, employer’s contribution towards public provident fund, and other expenses.

While making the statement, it is important to distinguish between employee’s contribution towards PPF and employer’s contribution towards PPF.

This is because only the later comes under employee benefit expenses. In the case of XYZ, the employee benefit cost for the year ending March 31, 2020, is 1500 crores.

Finance cost:

Finance cost can include transactions such as interest paid etc. for the funds that the company borrows. The borrowing can be from multiple sources such as banks or private lenders.

In the case of XYZ, the finance cost of the company for the year ending March 31, 2020, is ten crores.

Depreciation and Amortization:

Depreciation and Amortization are different as depreciation is charged on tangible assets while amortization is charged on intangible assets.

It is important to understand the difference between tangible and intangible assets under the concept of depreciation.

Tangible assets are those which exist in a physical form and add value to the business. It can include assets like land, machinery, etc.

On the other hand, intangible assets cannot be seen, but they provide economic value to the business. For instance, goodwill, trademarks, copyright, etc. are all intangible assets

Now, with the help of an example, let us try to understand why depreciation is important.

Suppose in the year 2019, XYZ purchases machinery worth one crore for assembling electronics. The life of the machinery is five years, which means that after five years, it will stop functioning.

Therefore, the cost of the machinery needs to be written in the next five years as it will continue to provide economic benefit for the same period.

To do so, we divide the value of machinery by its life and write it off every year as depreciation under expenses. This helps in representing a better picture of the business and does not affect the profits of a particular year.

A similar practice can be followed for intangible assets by charging amortization under the expenses side.

In the case of XYZ, the depreciation charged for the year ending March 31, 2020, is 600 crores.

Other expenses:

All the expenses that do not come under the above-mentioned items fall under this category. Due to this, it is one of the most elaborate items in the notes to accounts. Other expenses can include the following items:

• Rent
• Commission paid
• Donations
• Loss on Sale of current investments
• The sundry expense and many more.

In the case of XYZ, other expenses for the year ending March 31, 2020, are 4500 crores.

Calculating all the items under the expense side of the statement, we observe that the company has 29310 crores in the financial year 2019-20.

Profit Before Tax in Profit or Loss Statement

The Profit before tax, which is also known as operational income, can be calculated by adjusting the expenses and exceptional items against the Revenue.

In simple words, the Profit before tax can be calculated using:

Profit before tax = Revenue – Expenses – Exceptional items

= 37000 cr – 29310 cr – 90 cr

= 7600 crores

Note: Exceptional items refer to the amount paid for incurring expenses that are not recurring in nature. Therefore, it is separately mentioned.

Net Profit after Tax in Profit & Loss Statement Analysis

The Net profit after tax, sometimes simply known as net Profit, is the amount earned by the company after adjusting all the expenses and taxes. As it is visible in the above extract, the Profit before tax is 7600 crores.

To calculate the Profit after tax, we need to deduct the current tax as well as differed tax. The current tax is the tax payable by the business entity for the current year.

At the same time, deferred tax is the tax due in the current year but not yet paid. The addition of these two gives us the total tax liability for the year, which is 2600 crores. Therefore, the net profit after tax is 5000 crores.

It can be concluded that: Net Profit after tax = Net profit before tax – Applicable taxes

Earnings per share

EPS is one of the most commonly used items by analysts. In simple words, EPS tells us the earnings of the company per face value of the company’s share.

In the case of XYZ, EPS is 29.5 rupees per share for the year ending March 31, 2020.

P&L Statement & its Analysis – Conclusion

The profit and loss statement helps you know about the Revenue generated by the company and the expenses incurred for generating it.

The analyst uses this information for various purposes, primarily to know about the financial position.

The statement of Profit and loss is interlinked with the balance sheet and cash flow statement. This connection would be better understood in the other articles.

Let us now do a quick recap:

• Profit and loss statement, as per the general practice, is divided into four columns, namely particulars, note number, current year, the previous year.
• The financial statements help the users in analyzing the financial position of the company.
• The financial statements are primarily of three types i.e., Profit and loss statement, Balance Sheet, and Cash Flow statement.
• Statement of Profit and loss is an estimate because the company has the authority to revise the numbers if required.
• The general practice of making a profit and loss statement suggests that the values of the current year and previous should be written adjacent. As shown in the format.
• Revenue is the first major head in a statement of Profit and loss. It is also known as the top line of the company.
• The major heads under Revenue are Revenue from operations and other income.
• All the income that is generated by activities that are not operational in nature falls under other income. This can include commission earned etc.
• The Revenue from operations is a broad item and includes the Sale of products, Sale of services, and other operating income. Other operating income is incidental, and therefore, it is mentioned separately.
• Net Revenue from operations = Revenue from operations – Duty paid + Other operating income + Other income.

More Key Points on Income Statement Analysis

• The expense part of the statement of Profit and loss tells us about the list of expenses incurred in a year.
• Each item in the profit and loss statement can be explained further with the help of notes to accounts.
• Finance cost includes expenses such as interest paid etc. The company incurs finance cost when it borrows money to manage capital expenditure etc.
• Depreciation and Amortization are done to represent the true picture of a business. Through this, the company aims at spreading the cost of a particular asset over its life, as we did in the case of XYZ.
• Profit before tax = Total Revenue earned – Total expenses incurred – Exceptional items.
• Net Profit after tax = Profit before tax – Current Tax – Deferred Tax
• Earning per share or EPS tells us about the earning capacity of a company based upon a share of the company. In simple words, EPS gives information about the income earned per face value of a share. It is important to note, earning refer to the net Profit after excluding tax and preferred dividends.
• The formula to calculate EPS is: EPS = Net Profit after tax / Number of outstanding shares

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