Ian McIsaac

Financial Training and Consultancy
























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The Financial Statements in Detail



The Profit and Loss in Detail

    In chapter one we saw that the profit and loss statement shows the results of the group’s operations over a financial period. We shall now look at this financial statement in more detail and continue to use the example of the technology company.

    The first item to appear on the profit and loss statement is turnover. This shows the trading revenue resulting from selling goods in the marketplace. We can then see various ‘layers’ of profit: gross profit, operating profit, profit on ordinary activities before tax, profit for the financial year and retained profit. All these items provide us with information about the company’s operations and are described more fully below.
Revenue Recognition
    Revenue recognition refers to the point in the company’s production/selling cycle when a sale is recognised. This is straightforward for many types of company. For a food supermarket, for example, the sale is recognised at the point at which we pay for the goods at the check out. However, for many companies, there are a number of different options. For a furniture manufacturer which makes goods to order the range of possibilities includes the point the goods are produced, the point at which the goods are delivered to the customer, the point at which the cash is received or even, very conservatively, only once a warranty has expired. The point chosen can have a significant effect on the profitability of the company. It is always useful to try and understand the relevant revenue recognition policies of a company when assessing its financial health. There have been cases of over-aggressive revenue recognition recently, and the accounting bodies are currently looking at the issue closely.

Turnover is a good starting point for the analysis of any company. Increasing sales from one financial period to the next are normally a good thing and are a sign of an expanding market or increased market share, or both.

Remember, too, that the turnover figure just provides information about the value of sales made during the year and does not tell us about the cash received in respect of those sales.
Explanation of Profit and Loss Terms
    Turnover - This is another term for sales. It represents all the cash and credit sales made outside the group during the financial period. The notes usually provide a geographic breakdown of sales.

Gross Profit - The gross profit represents the company’s sales during the financial period less the costs of buying the goods that have been sold. It is sometimes referred to as a measure of the company’s success in the marketplace before taking into account the ‘supporting’ expenses such as administrative costs etc.

Operating Expenses - These come under broad headings such as administrative expenses, research and development (where relevant) and distribution costs. The notes to the accounts reveal a little more information about operating costs, especially with regard to auditors’ fees and depreciation.

However, the breakdown of expenses is not very detailed and certainly a lot less detailed than many managers are used to seeing in internal company management reports. One of the reasons for this is that companies do not want to reveal in the public domain too much commercially sensitive information which could be of value to competitors.

Depreciation and amortisation are described below in section 3.2.3.

Operating Profit - Operating expenses are deducted from gross profit to arrive at the next ‘layer’ of profit, operating profit. This is a key measure of the company’s trading performance before taking into account the financial charges of the business.

Net Interest Payable - This is the interest payable on loans, overdrafts and leases less interest receivable in the financial period on investments/bank deposits.

Profit on Ordinary Activities before Tax - This measures the profitability of the business before the deduction of tax and dividends.

Taxation - This refers to corporation tax which is the tax levied on company profits.

Profit for the Financial Year - This profit is the remaining profit available for shareholders.

Dividends - Dividends are that part of profits paid to the shareholders in proportion to the number of shares they own.

Retained Profit - The retained profit is reinvested in the business and added to the reserves as described in chapter one.

Earnings per share - This is calculated as the profit for the year after tax divided by the average number of shares in issue during the year. This is an important stock market ratio.

Alternative EPS calculations are also shown. Normalised earnings per share is shown after adjusting profit after tax for the effects of goodwill amortisation and is more indicative of underlying performance. In the final calculation the weighted number of shares is adjusted for the number of shares under option.

Revenue and Capital Expenditure
    We have pointed out that the profit and loss and the balance sheet perform different functions but you may have also noticed that both statements include items of ‘expenditure’. We have described the asset side of the balance sheet as showing how the money is spent and seen, for example, that a company will show its expenditure on plant and equipment (a fixed asset) on the balance sheet. The profit and loss also includes expenditure items such as salaries, rent and other administrative expenses. What determines which type of expenditure goes where?

The answer is that fixed asset items such as plant and equipment are put on to the balance sheet as they will be held for the long term. This is known as capital expenditure. Expense items such as rent, electricity and wages, which are consumed by the business more immediately, are put on the profit and loss. These items are known as revenue expenditure. The accounting bodies place great emphasis on ensuring that expenses which should appear on the profit and loss are not deferred to the balance sheet as pseudo-assets. The aim is to protect the profit and loss from manipulation.

Although the fixed assets are included on the balance sheet and have a life beyond one year, a portion of the original cost of a fixed asset is ‘used’ in each financial period in generating sales. A charge, known as depreciation, is made on the profit and loss in each financial period reflecting the ‘use’ of the asset and the ‘wear and tear’ that affects assets such as vehicles and plant and equipment. Assets are usually depreciated in equal instalments over their useful life (the straight line method of depreciation).

Depreciation is the allocation of the cost of an asset to individual accounting periods and should not be regarded as a way of providing for the replacement of an asset when it reaches the end of its useful life.

The reduction in value of an intangible asset is known as amortisation. Goodwill is normally amortised over 20 years from the date of an acquisition.
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