Read a Profit and Loss Statement

Investment in stocks needs thorough research about companies in which one wants to invest in. Before selecting stocks for one’s portfolio, one should go through various aspects of a company. One of the most important aspects for consideration of a company is its profit and loss statement.

A profit and loss statement basically summarizes the revenues, costs and expenses incurred during a specified period. The period is generally a fiscal quarter or a year. The Profit and Loss statement is also known as the P&L statement, Income Statement, Statement of Operations, and Statement of Earnings.

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It gives a whole picture of the financial health of a company and very simply tells whether a business is making profits or not. To analyse it properly, one should know its basics.

Let us discuss how to make sense of a profit and loss statement. First, we need to have a look at the P&L statement and see how it looks like.

This is the profit and loss statement of Lupin Ltd. for the twelve months ended March 31, 2018.

 

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1. Understanding the Revenue Side:

The revenues side of the P&L statement is called the top line of a company.

Revenues are basically the result of the sales or products that happened during the period of the P&L statement. The next line is excise duty. This is the amount the company would pay to the government. The revenue adjusted after the excise duty is the net sales of the company.

In the profit and loss statement above, Lupin’s net sales are Rs. 9846 crores. These should be compared with the net sales of the last year’s figure in order to know how well the company has performed in terms of sales. Then come the other operating revenues. They could be revenues through the sale of products or services that is incidental to the core operations of the company.

The sum of both net sales and other operating revenues is called Total Operating Revenues.

Other income means the income that is not related to the main business of the company. It includes interest on bank deposits, dividends, insurance claims, royalty income etc. If the amount of other income is large, then, one should be cautious and further investigate about them.

The sum of both the above items make up the total revenues.

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2. Understanding the Expense Side:

As the name suggests, expenses side of the profit and loss statement gives a detail about the expenses incurred by the company during the period of the P&L statement.

The first item on the expense side is ‘Cost of materials consumed’. This is the cost of raw materials that the company requires to manufacture finished goods. It is followed by all other types of expenses incurred by the company under different heads.

Since the item “other expenses” is large, the details should be checked in the annual report which is mentioned separately.

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3. Understanding Taxes, Depreciation & Profits

Taxes owed by the company to the government for the period of the profit and loss statement are mentioned under tax expenses. Depreciation is basically the reduction in the value of an asset over time.

That value is shown in the P&L statement.

Profit Before Tax – It refers to the net operating income after deducting operating expenses but before deducting taxes and interest. Exceptional items/ extraordinary items are treated separately on the P&L statement because they are not considered as a recurring expense. They are expenses occurring at one odd time for the company.

Net Profit after Tax – It is also called the bottom line of the Profit and loss statement. It is defined as a company’s operating profit after deducting its tax liability.

Almost all line items in the P&L statement have an associated note. These notes can be seen for greater clarity.

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4. Understanding Profitability Ratios

Financial ratios utilize items of financial statements to compute their values. One of the most important financial ratios is profitability ratios which are computed by using items of profit and loss statement. Profitability ratios help to measure the profitability of the company.

These ratios, when compared with last years’ ratios give a good comparison picture of how a company has changed for the better or worse. Similarly, these ratios should be used to make comparisons with the similarly sized competitors in the same industry.

The most common profitability ratios are discussed here –

EBITDA Margin or Operating Profit Margin

This ratio tells how efficient the company’s management is at the operating level. Let us first see how EBITDA is calculated :

EBITDA = [Operating Revenues – Operating Expense]

Operating Revenues = [Total Revenue – Other Income]

Operating Expense = [Total Expense – Finance Cost – Depreciation & Amortization]

EBIDTA Margin = EBITDA / [Total Revenue – Other Income]

PAT Margin

Profit After Tax (PAT) margin is calculated at the final profitability level. all expenses are deducted from the Total Revenues of the company to calculate the PAT margin.

PAT Margin = [PAT/Total Revenues]

Net Profit Margin

This tells us about the company’s ability to generate profits. A low Net profit margin would indicate higher costs and increased competition.

Net Profit Margin = Net Profits/ Net Sales*100

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5. Identifying Red Flags in Profit & Loss Statement

There are a few things in a P&L statement that should make an investor sceptical. Let us discuss some of them:

Manipulation in Revenues

There are some common ways to manipulate revenues like recording revenue before it is actually earned or recording sales that are incomplete because they are tied to some condition.

If one wants to know how to identify such manipulations, then, one should look at the revenues of the previous years to see if there is a sudden and unexplained change in its revenues.

Manipulation in Expenses

Companies can manipulate expenses through inventory manipulation. For example – A company could buy materials and then not record the full expense of the purchase or not record the purchase at all.

Sometimes, companies may exaggerate vendor discounts in order to decrease costs or not write off inventory that is out of date and no longer saleable. To identify any manipulation, one should check if expenses are changing in a way that is not consistent with previous periods.

Non-recurring Transactions

Some transactions that are not frequently made in a company like the sale of the company’s headquarters should be looked into to see if there is anything irregular. These sorts of items could show up as a “gain on disposal.”.

Companies could manipulate their earnings through these kinds of transactions.

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Cookie Jar Accounting

Public companies are under constant pressure to meet targets and consistently beat their earnings from the previous quarter. So, sometimes, companies might manipulate their revenues and expenses in various ways in order to paint a rosy picture for their investors.

Some common examples of cookie jar accounting are keeping reserves of revenue from previous quarters, without explicitly stating this, to show profitability in future quarters or shifting current expenses to a future period so as to show inflated earnings.

One should be beware of such manipulations and look deeply into the earnings of previous periods and management’s discussion of earnings. One must see if a lot of earnings are coming from “other income”.

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Final Words

We know that the profit and loss statement is one of the most important things to analyse before making a decision to invest in a company, especially for a long term.

For analysing a profit & loss statement, one should not only know about all the details of the profit and loss statement but also about the various ratios that can be calculated by using items of different financial statements to get a better understanding of the numbers.

Also, one must remember to identify the potential manipulations company might do in order to paint a picture of stability and continuous growth to show artificially how a company is highly profitable when in reality, the performance and profitability of the company are questionable.

Besides reading the profit and loss statement, one should always pay attention to what the company’s management has to say about the profitability of the company.

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