Most of us, knowingly or unknowingly, would have developed an unspoken animosity towards anything that has to with math or numbers. Whenever the thought of investing crosses our minds, we are stopped by this fear of numbers and calculations. Even the fundamental analysis done for investment purposes uses certain calculations. So it is high time you stop running from formulas and numbers and start understanding them. In fact, they are not as difficult as they look.
An important part of determining "whether or not to invest in a company" is reading their profit and loss statement. If you understand the art of reading and analyzing them, then half your job is done. Today we will be by your side and help you conduct a proper income statement analysis.
Understanding the profit and loss statement
As an investor, you would want to know where the money goes, how profits are made, sales, and various other aspects pertaining to the financials of the company you put your money into. So who do you ask all these details from, and where do you find them?
A profit and loss statement gives you each and every detail of what the company has done and how the cash moved during the entire financial year. Some call this as the Profit and loss statement or earnings and expense statement.
A good income statement analysis will help you comprehend the profitability, the capability, and the future of the company. Hence, it is of utmost importance to acquire knowledge regarding the analysis of profit and loss statements.
For example: assume a situation where the company's shares have increased all of a sudden out of nowhere. When making a P&L analysis or an income statement analysis, you found out that the profit was increased due to some non-operating activity and not from the mainline of business. Hence, you can protect yourself from getting carried away.
Further, you can find the financial statement of any listed company at Ticker screener. Type the company's name in the search bar and click on the P & L account to jump to that section.
Source: Stock Sccreener by Ticker
You can also find the profit and loss account in the annual report of the company.
Annual reports usually have two types of financial statements one is consolidated, and the other is a standalone financial statement. They both differ from one another in the following ways,
However, profit and loss statements analysis and income statement analysis suffer certain limitations as well. They are as follows.
- There is a high chance of misrepresentation of accounts. The company may knowingly or unknowingly hype up the figures.
- A comparison between the two companies is meddled by the difference in the usage of accounting policies.
Have you read our previous Master Class: 3 Ways to pick Undervalued Stocks ?
How to analyze Profit and Loss Statement?
We have now come to the most important section of the blog. We will see what the P&L statement items on which you should focus on and what they mean to you as an investor are.
Net sales – It tells you how much a company has made through the sale of its line of products. It is also called Revenue. Further, this number excludes all the costs and expenses. The net profit is extracted by making additions and deductions to this number. Hence, it is crucial for any investor to check this item.
Total expenditure – This includes all the expenses which the company has incurred from both operating and non-operating activities.
Operating profit – This comprises the profit which is made by the core business operations.
Other income – A business might have various other sources of income other than its main business line. Say a company has rented some of its office spaces or has invested in mutual funds, etc. In that case, all the income proceeds are included here.
Interest – A firm would borrow funds from various sources to meet its business obligations. It is required to pay off such borrowings over time. All those interests paid are included here.
Depreciation – Say you purchased a car. Over time it is subject to various wear and tear expenses. Following this, their value is reduced. This section contains all the non-cash expenses incurred by the assets owned by the firm over the period of time. It includes both short-term and long-term expenses.
Exceptional items – Whenever a company makes profits or incurs a loss from unexpected sources, then those things are included here. For instance, due to the coronavirus, the company might have incurred various unexpected losses. All those will be included here in the next financial year's P&L.
Profit before tax - As the name itself suggests, it is the profit before calculating tax. This amount is after deducting operating and non-operating tax but before payment of corporate tax.
Tax – This is the amount the company has to pay as tax. It is deducted from the profit before tax.
Net profit – This is the amount that is extracted after deducting and adding all the operating and non-operating expenses and incomes. It is also termed as net income or net earnings.
Adjusted EPS – This is the amount the company has made for every single share. In other words, it is earnings per share.
Source: Godrej Industries
Other important things which you might find on a profit and loss account are as follows.
Direct costs – This is also called the cost of goods. This includes the expenses incurred from the production or from the activities of the core business. Say you own a small candy production company. In that case, you will have to spend on sugar, flavors, wrappers, etc. All these expenses are included here.
Gross margin – When you subtract Revenue from direct costs, you will arrive at gross margin. It also tells you how much a particular product earns.
Operating income – This is also called EBITDA. In short, this is the earnings before tax & depreciation or amortization.
There is a popular misconception that prevails among amateur investors or beginners. They believe that holding an accounting or business degree gives you an edge over others in the stock market. But such things are often unreal. But it is essential that you be aware of the basics and formulas that will help you invest right. Hoping that you are well aware as to how to analyze an income statement, why not you try doing one? For further information, quickly click here, YouTube.
Hop on to the next blog series: How to Read the Quarterly Results?
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