Analysis of Financial Statements – Income Statement

Income Statement has many names such as Profit & Loss Account, P&L, Earning Statement, Operating Statement or Statement of Operations.

It is simply a summary showing revenues, cost and expenses and the resulting profit over a period of time usually one year. Two important key indicators are revenues known as the “top line” and profit termed as the “bottom line”. Profit is in fact, the bloodline as a firm must perform profitably in order to survive and remain solvent.

Income Statement is one of the statutory accounts that has to be filed annually with SECP (Security Exchange Commission of Pakistan.) Apart from filing with the regulators, the listed companies are required to publish their accounts as a part of disclosure requirement within six-month of the close of their financial year.

P&L statement is presented in a standard format for comparison purposes. This facilitates understanding and interpretation of the given figures. However, many companies try to distort to create a good impression to the outsiders. Such tactics can be un-earthed through comparing P&L account of one year with the previous year's account. But in any case, the bottom cannot be distorted which remain the same notwithstanding the distortion or manipulation. (It is presumed the accounts have already be finalized). For examples, sales can be inflated by showing them gross rather than net, operating income can be exaggerated by including capital gains etc. Listing the same type of expense under different headings year after year may raise a red flag.

The P & L account is typically shown in three distinct parts: (i) a trading account, showing sales minus production costs, (ii) other expenses, other incomes and tax provisions to arrive at after-tax profit , and finally (iii) appropriation of net profit after taxes.

P&L summery of Packages Ltd

Sales of Packages Ltd have increased by 35% due to inflation and increase in quantitative sales of paperboard, cartons, corruwall products and flexible packages. However, the production costs increased by a much larger proportion of 44% due mainly to increase in cost of raw materials, fuel and power costs. The company ended in net loss against high profit in the previous years. Two factors have contributed towards this nose dive: (i) decline in investment income by Rs.3.464 billion and (ii) increase in financial cost by Rs.1.295 billion (attributable to increase in lending rates and exchange loss).

Such results were not unexpected due to political instability, dramatic inflation and energy crisis. The company has provided a ten-year summery of its performance which shows that except in 2008, the company has all along been profitable.

VARIOUS FORMATS

There are many formats for presentation of P&L Account data: All follow GAAP, a standard set of rules adhering to requirements of regulatory authorities like SECP. This is necessary to show revenues, costs, expenses and profit for tax purposes. Also, it facilitates comparison of two different companies.

Single Step Format
Single Step Format
Multiple stage format.  It the same as shown at the top of this hub.
Multiple stage format. It the same as shown at the top of this hub.

ANALYTICAL FORMAT

Sales can be increased through showing closing inventories,-686, at sale value.
Sales can be increased through showing closing inventories,-686, at sale value.

SINGLE STEP FORMAT

It is simple to prepare and understand. It does not differentiate between costs and expenses or between operating or non-operating status of any item. It calculates the bottom-line or net income in one step.

All revenues and other income are lumped together. All costs and expenses are added up and shown in another group. The difference between the totals of two is either a profit or a loss

MULTIPLE-STEP FORMAT

This format is much more common. It meets the disclosure requirements as prescribed by the regulatory authorities.

It classifies revenues and costs in various categories. It explicitly displays important financial and managerial information that the user would have to calculate from a single-step income statement.

This format shows several important indicators such as gross profit, operating profit, Pre-tax Profit and Net Profit after tax. It makes clear distinction among production costs and selling and general expenses, non-operating income and non-operating expenses.

Extraordinary items, gains and losses, accounting changes, and discontinued operations are always shown separately at the bottom of the income statement ahead of net income.

ANALYTICAL FORMAT

In this format all costs & expenses are divided into two groups, (i) fixed and (ii) variables.

The variable portion is shown as deduction from sales to compute the contribution margin. Later, fixed part is deducted from contribution margin to arrive at profit before tax or loss.

This forms allow a quick way to calculate break-even point and estimate of future profits.

It would be noted that the top-line or bottom-line has not been changed in any format.

SOME OTHER VARIATION IN PRESENTATION

There are two views in showing the bottom-line: (i) the current operating concept and (ii) all-inclusive concept.

In the current operating concept, only those values are shown which have arisen out of ordinary, normal and recurring operations of a business entity. All non-recurring or unusual items are shown in the statement of retained earnings. This would give stability to the bottom line. Moreover, the investors are primarily interested in continuing income from operations

On the other hand, the all-inclusive concept of income includes all items, whether usual or unusual except for dividend distributions and capital transactions. According to this view, non-recurring and unusual items, whether income or loss, are part of the earning and should not be isolated.

CONCLUSION

An income statement, also called Profit & Loss Account, is a simple report on the operation of a company. This, in turn, reflects ability of an enterprise to generate cash internally termed as “net cashflows from operations”.

While analyzing, an analyst should re-arrange various items such as other income or expenses in their proper places by following guideline given for multiple-stage format. Once a correct summary of P&L Account has been prepared, it would facilitate a realistic projection of the past results.

As shown above, there are various format for preparing P&L account e.g. one-step, multiple-steps and analytical formats. Also, there are two views: (i) showing income and expenses only from current year operation. and (ii) including all transactions made during the year whether recurring or non-recurring. Any view can be adopted but consistency must be maintained.

Income statement is an integral part of annual accounts.

What ratios can be calculated from Income Statement, would be narrated in the next hub. It may be stated that ratios exclusively from income-statement or exclusively from balance-sheet can be misleading but ratios from both the statements give a better reflection on a company’s performance.

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Comments 6 comments

Rufi Shahzada profile image

Rufi Shahzada 7 years ago from Karachi

Dear Sir,

Very Informative HUB about Profit And Loss Account Statement. I 'll be waiting for the FINANCIAL RATIOS HUB because I am very keen to know, how exclusive ratios from BALANCE SHEET or INCOME STATEMENT can mislead...

Thanks!

RUFI SHAHZADA


hafeezrm profile image

hafeezrm 7 years ago from Pakistan Author

Thanks Rufi, give me one week for the next hub. Current ratio is calculated from Balance Sheet. Suppose it is 2.5:1 which is considered good. But when you take into account both balance sheet and income statement and caculate turnover ratio, you may find that the turnover of current assets was very poor. Now the current ratio would look equally undesirable as the company is doing nothing but just sitting on pile of current assets.


Rufi Shahzada profile image

Rufi Shahzada 7 years ago from Karachi

Great Sir,

Now I understand, but I will wait for the HUB because I want to study the impact of both the statements on LIQUIDITY RATIOS and PROFITABILITY RATIOS.

Thank You!

RUFI SHAHZADA


Highest CD Rates 7 years ago

I think you have explained accounting very well here. Though i don't belong to you country but your blog would be helpful for many people related to this work. I like your professional knowledge.


Philipo profile image

Philipo 6 years ago from Nigeria

Very inforamtive and educative hub. Thanks for sharing.


Jennifer Bhala profile image

Jennifer Bhala 6 years ago from Upstate New York

Nice Hub. Great Information.

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