Understanding Financial Statements: Making More Authoritative Decisions (5238BC)
There are three types of financial statements; namely, Income statement, Balance sheet and Cash Flow statement. These statements are interdependent and provide critical financial information to help assess the company’s performance for managers. Shareholders use these information to find how their capital were being used and how much return they will get. For investors and bankers these reports give information to analyze and decide whether to invest in the company’s opportunity and provide bank loans if any. Income statement tells whether the company is making profit. Balance sheet can give indication how the assets are being utilized in pursuit of profits. Cash flow inform how the cash moves in and out of company in operations, acquisition and financing activities. a. Discuss the significance of profit and loss account account (income statement). statement). Explain the process of preparing this account. How is the operating profit different from net profit Significance of Profit and Loss Account
Profit and Loss account (P&L Account) gives information about whether the products/services provided by the company are profitable are not for a specific period of time, typically for a Month, Quarter or Fiscal year (1 financial year). Profit and Loss account also provides the information whether the company will be in a position to pay its expenses and remain in business through the sales it generates in the same period of time. P&L account provides 3 critical information. First, Revenue generated through sales. Second expenses incurred during the same period. Finally the difference between revenue and expenses, profit or loss depending on whether the revenue has exceeded expenses or lesser than expenses. Basic Equation of P&L Account Revenue – Revenue – Expenses Expenses = Net Income (or Net loss) P&L Account will always be for a period of time and can be prepared for a company or by division wise in case of multi-divisional organizations. P&L Account is used across different departments to assess specific information to help in decision-making. A Sales manager can look at the profits and decide on pricing strategy, discounts. Marketing manage can identify the product lines that generates more revenue or lesser revenues and decide on which products to focus on or phase out. Human resources department can assess which division requires more resource and on which areas to make hiring decisions. When the P&L Account tracked over period of 2/3 years, one will be able to spot trend of the company as to t o whether the company is growing or making continuous losses and possible reasons. For publicly traded companies, net profit is used to determine the earnings per share (net profit/Outstanding Shares) to determine t he success of the company and ultimately predict whether share prices will go up/down.
Preparing Profit and Loss Account
Profit & Loss account contains three parts. Revenue, Expenses and Profits 1. P&L starts with the company’s revenues i.e., the currency amount of products or services sold by the company to its customers during the specific period. Depending on the company’s nature, and also the practices adopted based on GAAP (Generally adopted Accounting Practices), the company may decide to book a sale as revenue when the product/service is sold or delivered or distribute it over a period of time to smoothen the revenue. This is purely left to the company’s practice of timing of recording revenue. The company may also generate revenue through interest earned through investments and other sources of income. Growth in revenue between two periods is referred as Topline growth. 2. Second Part of P&L is the expenses incurred for the same period of time. Expenses can be classified as Cost of Goods Sold (Product) /Cost Of Services (COS), Operating Expenses, Non Cash Expenses and finally Interest and Taxes. 3. Next to revenues, all the direct expenses associated with selling product or delivering services has to be recorded. This will include cost of materials, Labor costs to turn them to finished goods in case of products, Employee Salaries, All the infrastructure and travel costs incurred to deliver the services in case of Services will be part of Cost Of Goods Sold or Cost of Services. 4. Difference between Revenue and COGS/COS is called Gross Profit. This will be the third step, recording Gross Profit. Gross Profit signifies the basic profitability of the company. Gross Profit should be sufficiently large enough to pay for the operating expenses, depreciation, interest and taxes and finally leave a net income that can be distributed to the investors. This is a key measure to be monitored by all the stakeholders. If the gross profit is low, it can be either due to less revenue (revenue recognition) or higher COGS/COS. 5. Gross Profit also uses to differentiate above the line and below the line of P&L account. Above the line refer to COGS and generally it will vary based on the revenue and growth. Below the lines are fixed expenses with low variations 6. Next Gross Profit, Operating expenses are to be recorded. Operating expenses are all the in-direct expenses like Sales, Administration, Rent, Overheads, stationaries and other costs that directly not involved selling in product/services 7. Difference between Gross Profit and Operating expenses is to be recorded as Operating Profit or Earnings Before Interest Depreciation and Amortization (EBITDA) 8. Next, Depreciation will have to record. Depreciation is the portion of the f ixed asset investment that will be considered as part of expenses for the specific
period. Amortization is the part of value of intangible assets like patents that is considered as expense in the specific period. These are also known as noncash expenses as in these cases the investments would have already been made under fixed asset 9. Some organization record one-time expenses to record write offs, costs incurred due to acquisition. They will need to be recorded finally. 10. Interests based on the outstanding debts and Taxes will be calculated based on the prevailing government rates 11. The difference between the Operating Margin and Sum of Non Cash Expenses, One time expenses and Interest/Taxes is recorded as Net Income. Net Income is also known Bottom Line and this profit that the company generates by being in the business for that period. A positive amount indicates Profit and a negative amount means the company is in loss. Difference between Operating Profit and Net Profit
Operating profit indicates the profit made by running the business after incurring all kinds of expenses in that period. Operating Profit is indication of how well the company is managed. Operating Profit is also indicator as to whether the company will be able to pay their debts and earn money for the shareholders. Vendors can identify if they will get their payments. A healthy and growing operating profit signifies a growing organization with lots of opportunities. Net Profit is what’s left over after all possible expenses are paid out. Analysts track this determine whether the company’s share price will grow or decline. This is also the value that is given back to shareholders as return on their investment. Shareholders can be given dividends out of this net profit or the net profit can reinvest back in company for further growth. b. Discuss the significance of balance sheet and cash flow statement. Analyze the impact of profit and loss account on balance sheet and cash flow statement Balance Sheet
Balance sheet is gives financial performance of an organization as snapshot at any points. It gives a picture of what the company owns – assets, what it owes – liabilities and what’s the value in the form of equity from the investors. The basic equation is Assets = Liabilities + Owner’s Equity 1. Balance sheet provides information about the assets owned by the company. The assets can be in the form property, parts and equipment called as Fixed Assets. Fixed asset values will be reduced over the period of usage of these assets by value of the depreciation. By comparing the fixed assets across multiple Balance sheet, one can infer whether the company has invested large amount of money in the company or using the company as “Cash Cow”, to maximum utilize only existing investments
2. Current Assets are Cash or Cash equivalents that can be converted in cash within the year. The cash in hand, accounts receivables, prepaid expenses; Inventory will be recorded under Current Asset. 3. Fixed assets and Current assets are to be funded through either loans, which will be recorded under long term/ short-term liabilities, or through capital infusion in the form equity. Any payments to be made within the year like accounts payable will be part of current liabilities 4. Difference between current assets and current liabilities provide working capital requirements to survive/sustain the organization in short term. Too small working capital will result in the organization’s inability to pay up its short-term obligations and immediately will require assistance in the form of external funding. Whereas too large working capital value could be an indication that the company’s cash locked in account’s receivables or in inventory resulting in high carrying costs. By analyzing the values of Accounts receivables or inventory, managers can make appropriate efforts to bring down the values 5. Current ratio, ratio between current asset and current liabilities will help in determining whether the company will be able pay their short term obligations. Quick Ratio/Acid Ratio will help in analyzing whether the company will be able to pay their short term obligations without selling their liabilities 6. Capital invested, shares available, retained earnings (net profit) will be provided in balance sheet 7. Balance sheet helps in calculating financial leverage of a company through debt to equity ratio. Higher the ratio, company aggressively funds their growth debts, which can again impact profit, as the interest for the debt wil l increase. Cash Flow Statement 1. Cash Flow statement gives accurate picture of the actual cash available at any point of time and also how much cash came in side the organization and how much the organization spent. While P&L account and balance sheet is based on the estimations and may include bias, Cash flow statements are based on the actual cash situation in the company. The cash flows are tracked primarily on three heads. 2. Cash Flow from Operations: Cash flow from operations tracks the cash came in the form customer’s paying up for product/services sold and company spending for various operational activities like salaries, rent etc. A positive operating cash flow signifies that the company is doing the business well and turning the investments in to profits. Whereas a negative cash flow indicates that the company doesn’t have enough cash and needed to depend on loans/investments 3.Cash Flow from investing: Cash flow from investing tracks the amount invested in fixed assets like property, plant and equipment’s and also if any fixed assets are sold out during the same period. This part of cash flow tracks, Company’s expansion plan or their approach to liquidate some of the fixed assets that could again be used for operational activities.
4.Cash Flow from Financial activities: Any new investments made through external investors or long term loans or returns from investing in financial markets are tracked as cash inflow in this category. While payment of loans, dividends are tracked as cash out. 5. Cash flow statement is important in assessing whether the company will be able to pay its bills – being Solvent. Impact of P&L on Balance Sheet and Cash Flow Statement
P&L Account, Balance sheet and cash flow statements form triad of reporting tools available for anyone to analyze a company. A change in one report has an impact on the other two reports. The estimation or bias considered at one report also reflected in the other reports. 1. Net income or net profit, which is the final result in P&L, will be added to Owner’s equity in balance sheet. If any dividends are paid then the net profit will be reduced to value of the dividend. The owner’s equity will increase or decrease based on whether the company makes profit or loss 2. Cash on Hand and Accounts receivable has a relationship with the sales revenue recorded in the P&L account. An increase in revenue will show increased amount of Cash in hand or Accounts receivables 3. Similarly increase in cost of goods sold or operating costs can increase current liabilities 4. P&L account records depreciation of fixed asset as an expense before calculating net profit. This depreciation will also be used to reduce the value of fixed asset in the balance sheet 5. One can analyze a decision to whether stock the material or sell in volumes instead of high value orders or invest in IT systems can be done using the combination of P&L and Balance sheet. For e.g., a decision to increase inventory will increase the value of inventory in current asset and also increase the value of current liability (accounts payable). When the payment is processed Cash decreases and the accounts payable also will decrease in Balance sheet. This will also result in having the inventory on your company before it can generate revenue. Hence there will be increase in expenses to carry the inventory in company which will increase your operating expenses 6. Relation between Cash Flow statement and P&L account can be explained simply as in case of all cash transactions and no considerations of depreciation net income will always be equal to cash in hand. 7. Cash flow statement can be prepared using P&L statement in reference with beginning and ending balance sheets. 8. An increase in net profit can indicate higher cash flow from operations. 9. Accounts receivable which results from selling decreases the cash in hand for the period of time as it indicates that a sale is made but payment is yet to be done 10. Current Liabilities which results expenses in COGS/Operating expenses is company’s obligation to pay increases the cash in hand 11. Based on the cash position, one can take a decision to incur a new expense or defer it for another time 12. Increase in depreciation in P&L may also be a result of company investing in new assets
P&L account, balance sheet and cash flow are dependent on each and monitoring key performance of the company. A change in one statement affects the other positively or negatively.
