Profit, Profitability & Income Statements Notes

Financial Accounts

• Financial accounts are financial records of business transactions.

• They provide essential information to groups both within and outside the organization.

  • Income statements.

  • Statements of financial position.

Profit

• Profit = Total Revenue - Total Costs (TC)
  Profit = Total\ Revenue - TC

• Profit margin = Percentage of final selling price that is profit.

• Total Revenue:

  • Money received from selling products and services.

  • Selling price per unit x Quantity Sold.

How to Increase Profits

• Increase revenue by more than costs.

• Decrease the cost of making products.

• Both of the above.

Importance of Profit

• Reward for enterprise & risk-taking.

• Source of finance.

• Indicator of success.

• If investors want profit -> interest.

The Income Statement

• Covers a year, normally.

• Profit (P) = Sales Revenue (SR) - Total Costs (TC)
  P = SR - TC

• Types of Profits:

  • Revenue: This is income received by the business from sales.

  • Cost of Sales (COS): Direct costs, e.g., those costs directly involved in production or core activities during the year.

  • Gross Profit (GP): Revenue - Cost of Sales. This shows how efficiently the business is converting raw materials into finished products, but excludes overheads (admin and other expenses). This is very important.

  • Administrative Expenses: Overheads or indirect costs not involved directly with production (Insurance, administrative staff, offices costs etc.).

  • Operating Profit: Gross Profit - Administrative Expenses. A very good measure of the business' profits, as it shows the profit of the business from the full range of its activities but ignores exceptional items that could distort this figure such as finance & taxation costs.
    Note: Operating profit is profit made in all of business activities..

  • Finance Costs & One-Off Items:Interest received usually from money in the bank less any interest paid out for loans etc. This can also include the loss or gain from 'one-off' activities, such as selling a loss-making division of the business.
    Example: Bank loan.. These are costs outside the business and not related to running the business-

  • Taxes: Taxation is a cost to a business, although many multinational businesses are finding loopholes in global taxation systems to avoid paying too much. Current UK corporation tax rate is around 25%. This figure will vary between countries.

  • Profit for the Year (PFY): Operating profit - (Net finance, One-off items and Taxation). This is a useful figure to the owners (in this case shareholders), as it shows how much they benefit from being owners and will allow an overall view to be taken as to whether the business is worth buying shares in (investing). Note: PFY determines retained profit & dividends..

    • Core Activities:

      • Directly involved in making a product.

    • Non-Core Activities:

      • Company car.

      • Salary of staff in different departments/selling of product.

  • Dividends to Shareholders: The business will need to decide how much of the 'profit for the year' should be given to shareholders and how much should be retained to be used to help grow the business. This will depend on the objectives of the business, and the views that shareholders may take on this.

  • Retained Profit: Often known as retained earnings, this is the profit that is left over that can be reinvested and used by the business to help it grow. This will be an important source of finance for the business.

Income Statement Example: Landrytastic PLC (£ '000s)

Key Takeaways:

• Smaller sized business different sized profits (figures on accounts).

• Comparing profit to size of business accounts.

• Not as good at turning revenue to profit in 2020.

• Less profitable in 2020, determines retained profit and dividends.

Income Statements - Benefits

• Shows the trading activity (revenue, costs, profits) over a time period.

• Shows how much profit is left to give to shareholders or to retain in the business.

• Legal requirement for businesses to keep accounting records.

• Useful for managers to make decisions.

• For companies (Ltd & PLC), these will be published and publicly available.

• Should be compared from one year to the next, or compared to other similar businesses.

• Will be useful for banks to assess loan risk, as well as guide prospective investors.

  • Opportunity cost/trade-off decision.

• Compare businesses in the same sector but of different sizes using profitability ratios.

• Find a trend - are figures improving?

• Should they loan?

• How much dividend?

Analysing Accounts

• Comparing different values on the accounts.
  E.g. profit vs Sales revenue.
  Check for trends.

• Comparing values from one year to another.

• Comparing values against similar businesses operating in the same market.
  Benchmarking bad ratios vs another business.
  *Need to know business method of operation.

Case Study: Landry Retail Trading Ltd

• Buys chocolate bars for £1 and sells them for £3.

• Started with 500 chocolate bars, bought 2000 more during the year.

• Ended the year with 400 chocolate bars.

Questions:

1. How many chocolate bars did the business sell during the year?

2. What was the ‘Cost of Sales’?

3. What was the Gross Profit?

4. If the business had costs of £500 for insurance and rent, what is the Profit for year (Net profit)?

5. If a 10% dividend is paid to the shareholders what is the amount of Retained profit?

Profitability

• 'How much profit is made compared to the sales revenue that was used to generate the profit.'

• Profitability and profit are two different things.

Profitability Calculations

• Gross Profit Margin (GPM)
  GPM = \frac{Gross\ Profit}{Sales\ Revenue} X 100

• Operating Profit Margin (OPM)
  OPM = \frac{Operating\ Profit}{Sales\ Revenue} X 100

• Profit for the year Margin (PFYM)
  PFYM = \frac{Profit\ for\ year}{Sales\ Revenue} X 100

Key Takeaways:

• Firm A makes £20 million profit, Firm B makes only £10 million profit.

• While Firm A makes more profits, it may not be ‘as profitable’.

• We will only know this when profitability calculations are applied to both businesses comparing their profits to the revenue made.

• This gives us an idea of how well the business can turn revenue into profit.

• Better at turning revenue into profit.

Profitability Calculations Example: Landrytastic PLC

Calculations:

• GPM (2021) = (\frac{9000}{30000} * 100) = 30%

• GPM (2020) = (\frac{15000}{25000} * 100) = 60%

• OPM (2021) = (\frac{5900}{30000} * 100) = 19.67%

• OPM (2020) = (\frac{12000}{25000} * 100) = 48%

• PFYM (2021) = (\frac{4900}{30000} * 100) = 16.33%

• PFYM (2020) = (\frac{11200}{25000} * 100) = 44.8%

Comments on Profitability:

• Profitability numbers become worse.

• Increase in costs of raw materials decrease productivity & old machines decrease efficiency.

• Not as profitable as it was.

• Less relevant stuff irrelevant to production of goods -> shareholder/investor to dividends.