Income Statements (Profit and Loss Accounts)

State some purposes of the businesses’ income statement.

• Allows shareholders/owners to see how the business has performed and whether it has made an acceptable profit (return).

• Enables comparison with other similar businesses (e.g. competitors) and the industry as a whole.

• Allows providers of finance to see whether the business is able to generate sufficient profits to remain viable.

• Allows limited companies to satisfy their legal requirements to report on the financial record of the business.

Outline the main components of a trading, profit and loss account.

• Sales Revenue – Revenue shows the total value of sales made to customers. This is the total amount of money made by the business from selling goods and/or services.

• Cost of sales - The direct costs of generating the recorded revenues. This would include the cost of raw materials, components, goods bought for resale and the direct labour costs of production.

• Gross profit - The difference between revenue and cost of sales. Gross profit is an indicator of how efficient the business is at making and selling its product.

• Expenses – These are the operating costs and expenses that are not directly related to producing the goods. These may include utility bills, wages and salaries, marketing costs, transportation costs and administrative expenses that a business incurs.

• Net profit (operating profit) is an indicator of how efficient the business is overall. This is because all the business’s revenues and expenses are included in the calculation. It assesses the management of all the costs in the business, including both fixed costs and variable costs

• Corporation tax – Limited companies will be required to pay tax on the net profit the business makes. This tax is paid to the government.

• Profit after tax – This is simply net profit minus corporation tax.

• Dividends - The shareholders decide how much of the profit after tax that should be paid out to them. A dividend is simply a % share of the profits that are distributed to shareholders.

• Retained Profit – This is the amount of money that will be kept by the business and could be used in the following year. It is often seen on a balance sheet as part of the capital employed.

How do you calculate the gross profit margin?

GPM= Gross profit / Sales Revenue x 100

How do you calculate the net profit margin?

NPM= Net profit / Sales Revenue x 100

What can be considered when analysing a business’ income statement?

• Comparing performance over time

• Comparing performance against competitors or the industry in which the business operates.

• Benchmarking – A comparison against other businesses who are not direct competitors can also be useful, particularly if they help set the standard that the business aims to achieve. However, if the benchmark business operates in a very different industry, with significantly different profit margins, then this kind of comparison would not be worthwhile.

What components of an income statement should be targeted when analysing a business’ financial performance?

• Sales revenue – If this is increasing or falling then it could be a sign that the business is attracting or losing customers. This can then be analysed in relation to the impact it may have on market share and/or profit. Reasons for the changes could also be addressed, such as effective/poor product range or advertising campaigns, competitor’s actions or external factors, e.g. a recession.

• Cost of sales – If this is increasing or falling it would impact on gross profit. Therefore, the reasons for the changes need to be discussed, such as increasing costs of raw materials/stock or labour.

• Gross profit – This is an indicator of how efficient the business is at making and selling goods and/or services. Therefore, if this is increasing, it is positive; if it is falling, it is negative. It would be possible to assess the reasons for this, which would involve issues with sales revenue and/or cost of sales.

• Net profit – This is a true indicator of profit and the efficiency of a business. If this is increasing or decreasing, then the reasons need to be addressed and the importance discussed. For example, if net profit is falling then it could be due to sales revenue falling, cost of sales increasing, gross profit falling, expenses rising or a combination of all these.