Understanding Profits And Losses

Published in Investing on 14 July 2009

If we want to understand a company report, we need to know what all the income, expense and profit figures mean.

Last week we did a quick overview of company reports, and we saw there are four main parts to a report that we, as investors, need to inspect carefully. Those are the three financial statements (the Income Statement, the Cash Flow Statement, and the Balance Sheet), and the notes to the accounts -- all the wordy stuff that fills up the rest of the pages counts for little. In the next few instalments, I'll take a brief look at each in turn, and today it's the turn of the Income Statement.

The top line

The very first thing we'll see, right at the top, is a revenue figure, which represents the total value of the company's sales during the year. We might sometimes see this figure broken down into revenues from continuing operations and revenues from new business, which is a useful way of comparing like with like for a company that is expanding into new businesses or disposing of old ones -- we can use the breakdown to help see how its core business is performing year-on-year. And different companies might show slightly different breakdowns, but we'll always see a figure for total revenues.

Costs and profits

From this we will usually see a company's cost of sales stated, which is then subtracted from revenues to provide its gross profit. The cost of sales covers all of the variable costs associated with the actual production of whatever it is the company sells. So if a company is manufacturing something, its cost of sales will include the costs of its raw materials, labour, etc.

In addition to direct costs of sales, there will be a number of overheads that a company has to pay too -- for example, sales and marketing, research and development, various administrative and other costs. These are all totalled, and subtracted from the gross profit figure to give us the company's operating profit (that is, the profit it earned from its actual operations, after accounting for all its operating costs).

We're still some way away from the bottom line here, but operating profit is a useful figure for comparing the efficiencies of different companies in similar businesses -- a company with a higher operating profit as a proportion of its revenues (its operating margin) is, other things being equal, likely to be operating more efficiently.

Finance costs and taxes

Separate from operating costs, we will next expect to see a statement of the company's finance costs (and, if it has any, finance income). Interest paid on borrowed money and interest received on cash in the bank will show up here, as will banking charges, etc. It is important for us as shareholders to be able to see finance costs separated from operating income and costs, as they both tell us different things.

We might next see a few extras, like profits and losses associated with joint ventures, which account for our company's share of other companies that it part owns or operates in partnership with, and these will next be added or subtracted.

The bottom line

After that, we're pretty soon left with profit before tax. And, fairly logically, tax to be paid, followed by profit after tax. And this is the bottom line -- the final profit (or loss) attributable to shareholders of the company. This figure is then divided by the total number of shares in existence, to give us the earnings per share figure. But we're still not necessarily at the end of the calculation yet, as there are often potentially more shares that may come into existence -- for example, options that have yet to be exercised . And so we will often see a fully-diluted earnings per share figure, based on the total number of shares that could potentially exist if all committed allocations, options, etc are realised.

But there is one thing I have ignored so far…

Exceptionals

Something we may often see in a company's income statement is a breakdown of exceptional items. These are often glossed over in the wordy blurb further up the report, but they are very important to us. They represent items, both income and expenses, which derive from the company's ordinary activities but which are unusual in size or are infrequent. Costs associated with reorganizations, such as acquisitions or mergers, provide a common source of exceptionals, as do terminations of business interests and disposals of unwanted assets.

We tend to see exceptional items more often in the accounts of larger companies, and they can make our evaluation of the worth of such companies that bit harder -- though they show up in the annual report, they are really applicable to a number of years of business rather than just that one year. If exceptionals are frequent and sizeable, we might want to look for more of a safety margin in the share price to compensate us for the extra risk due to the associated uncertainties.

Finally…

Some investors don't look any further than the Income Statement (and it is the statement that figures most prominently in headline announcements), but that is somewhat foolhardy, as one vitally important thing we always need to be aware of is that the various incomings and outgoings do not necessary correspond to cash -- transactions are recorded at the time they are made, even if, through various credit agreements, payment schedules, etc, the cash might not actually be handed over yet.

We'll look at cash more closely next time.

More Investing Basics from Alan Oscroft:

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

theRealGrinch 14 Jul 2009 , 5:08pm

the chairman's outlook is usually a good indicator of how bullish the company is. Acid test is useful too.

RobinnBanks 17 Jul 2009 , 12:46am

Simply put, and a very good account Alan!
I look forward to the others in this series.

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