Understanding Comments on Profit and Loss Account Items

Many methods and techniques are used in the analysis of financial statements including profit and loss accounts. They include (i).Trend analysis (Historical standard): A comparison is done of current performance with past figures of the firm. (ii). External Standards: Comparison is done between the two business concerns of the same size, which can also be made with ‘Industry average’. (iii). Goals/Corporate planning & Policies: Comparing the actual performance with the budgeted performance, to find out whether actual performance is good, to the set goal in the prevailing circumstance). Comparison of Profit & Loss statements with the corresponding period of previous years gives us a fair idea of an increase or decrease in sales, increase or decrease in manufacturing cost, increase or decrease in overhead charges, financing charges, etc.

A profit and loss account is made to ascertain annual profit or loss of business. So first look at the bottom line (Net profit) of the profit and calculate the margin of profit. Profit margin is a common measure of the degree to which a company or a particular business activity makes money. The margin of profit is expressed as a percentage.

When assessing the profitability of a company or a business enterprise, there are three primary margin ratios to consider: gross, operating, and net. Below is a breakdown of each profit margin formula.

Gross Profit Margin = Gross Profit / Revenue x 100

Operating Profit Margin = Operating Profit / Revenue x 100

Net Profit Margin = Net Income / Revenue x 100

Analysts compare the profit margin with previous years and then comment on whether the net profit corresponds to it represents the portion of a company’s sales revenue that it gets to keep as a profit, after subtracting all of its costs.

Secondly, they look at the sources of income and expenses. The biggest expenses related to sources of higher income are identified and compared year-over-year numbers.  Comments are made on logical relationships between numbers.

Sources of revenues:

Find out additional sources of income during the year that may appear to be profitable for the business. However, it is important to find out whether any of them are overly time-consuming with very low margins. In such cases, management has to decide whether to continue with such business or divert the business activities for additional income.

The next step is to review the cost of goods sold. It would make sense for the cost of service or goods sold to go up as revenue goes up since these expenses are directly related to your product. The opposite would not make sense and should be a red flag. The management or owners can also think over the questions like “Is there a way they can reduce these expenses?” Finding ways to decrease the cost of goods sold will ultimately increase the bottom line and profit margin.