All business owners, accountants, current and prospective investors need to evaluate the profitability of their business in order to minimize the risk of incurring losses. How can they do that? They can do it by creating and analyzing an income statement, which is also referred to as a profit and loss account (P&L account).
A profit and loss account or income statement is one of the three significant financial documents used to measure and analyze the overall financial health of all types of business entities. The remaining two are the balance sheet and the cash flow statement. The income statement does focus on the revenues and expenses of a company for a particular year. It can be prepared and released on a timely basis. For example, some companies release it annually; others do it semi-annually or quarterly. It is completely based on business requirements.
On the left hand side of the income statement, all the administrative, selling and distribution expenses are listed. While on the right hand side of the statement, the incomes and gains are listed. The common administrative expenses consist of office rent, repairs and renewals, travelling expenses, telephone and postage, legal charges, insurance, audit fees and others. Advertisement expenses, free samples, sales commission, bad debts and carriage outward are listed under the head of selling and distribution expenses. The aspects covered under the head of the incomes and gains include discount received, rent received, bad debts recovered, non-trading income, commission received, profit on the sale of assets and others.
Here is an example for you. John has started his company called TechSoar three years ago, but he never monitored his expenses and incomes due to some reasons. One fine day he approached a bank for business purposes. The bank has asked him to produce the income statement for the last three months to transact further. When he started preparing, he realized that he should have done it before to control his finances. The biggest problem he faced was the tracking the historical data. The gist of the example is just like big business houses even small businessmen should prepare and maintain the profit and loss account periodically.
If you have been asked to review the profit and loss account, start by checking the math. One should be good at simply addition and subtraction. Nothing more is required. When start adding and subtracting the values, you get to know more about the statement. That’s it!
Step 1: Look at the bottom line
The reviewer needs to look at the bottom line first. There are two chances: 1) you may find a positive number and 2) there may be a negative number. The positive number indicates that the company has earned a sizeable amount of profit. On the other hand, the negative number indicates that the company has not earned any profit and is running under loss.
Step 2: Find out incomes
Income is the simplest component of the income statement. It is because there shall be a single number that replicates the total revenue earned by a company. The fastest way to enhance profitability is increasing revenues. The reviewer has to make sure that the income has some value to the business under consideration.
Step 3: Assess overheads
In the earlier section of this article, we have discussed about the common expenses shown on the income statement. Not all businesses are alike when it comes to expenses. For example, salary is the biggest expenses for service-centered businesses whereas the biggest expense for manufacturing companies is the material cost.
Step 4: Watch for trends
Most income statements consist of 3 reporting periods. So, the reviewer has to watch for the performance of the company over the course of the reporting periods. As far as the numbers mentioned on the income statement, the reviewer has to think logically. Explanation should be sought for unnecessary things included in the statement.
Step 5: Interpret the income statement
If possible, look at the previous income statements for the last 4-5 years to read and analyze the trends. It is important because not all companies can earn profits every year. They may incur losses this year or recover the losses incurred last year. The companies that maintain their profitability consistently are considered to be highly liquid.
Step 6: Think about logical relationships between numbers
Yes, there exists a logical relationship among numbers. Understand it even though it is difficult. Let’s consider an example here. For the financial year 2017-2018, ABZ Group (assumed) had reported a net profit of Rs.10.2 crore. For the next financial year, which is 2018-2019, the company had booked a net profit of Rs.10.9 crore. What does it indicate? Yes, there is a rise in the net income. The question now is how the company managed to increase its profit? Interestingly, the sales figures remained unchanged for the last two years. Then, how is it possible? During the financial year 2018-2019, the company had reduced its maintenance expenses by 60%. As a result, it witnessed a reasonable hike in its profit. The net profit will increase if there is a rise in sales and vice versa. It will also increase when there is a downfall in the total expenses. This is how all the numbers mentioned on the income statement are interrelated. The reviewer has to understand that. That’s it!
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