Successful investing is about finding stocks of companies with strong fundamentals. In the simplest terms, the fundamentals of a company is the information about its financials and management both quantitative and qualitative.
This includes reading some and analyzing some important financial reports and ratios. Today, let’s talk about the profit & loss statement of a company and how you can read and analyze it to assess its fundamental strength. Read on!
An income statement can tell you how the company has performed over a given period. Every company has expenses, sales (of product and/or services), and resulting profits.
Before investing in the stock of a company, it is important to understand how it has performed and this statement is a good place to start. Hence, it is important to understand various heads in the Profit & Loss statement and how to assess them. These include:
Let’s look at each of them in detail
Revenue is the total amount of sales made by a company during a given period. So, if you are looking at the income statement of the past year, then the revenue sub-heading will tell you about the amount of sales that the company has made over the period. Please remember that this is not profit but the total amount of sales.
Expenses or the cost of goods sold is an important factor while assessing the company’s financial statements.
If a company manufacturing t-shirts has revenue of Rs.5 lakh, then what was the cost of manufacturing, transporting, and selling those goods? Also, what was the cost of human resources (employees)? rent and other expenses?
The idea is to understand how much did the company spend to achieve the revenue amount as per point I? All the expenses must be considered under the ‘Expenses’ section.
If you deduct expenses from revenue, you get the operating profit of the company. So, if the company earned Rs.5 lakh in revenue and incurred an expense of Rs.2.5 lakh, then its operating profit is Rs.2.5 lakh.
It is important to remember that you deduct only those expenses that were used for the company’s operations. For example, if a company manufactures t-shirts, then you must only deduct those expenses that were incurred in making t-shirts.
A company can have many other expenses. Hence, remembering this part is important
The Operating Profit Margin tells you how well the company has been using its resources to generate profits. So, if a company’s revenue is Rs.5 lakh, expenses are Rs.2.5 lakh, and Operating Profit is Rs.2.5 lakh, then
Operating Profit Margin=2.5 x 1005=50%
Let’s say that you are analyzing the income statement for the period January-December 2019. To understand the performance of the company, you need to compare this ratio with that of the previous year.
Assuming that the operating profit margin for the period January-December 2018 was 45%, and that of the period January-December 2017 was 40%, then the company has been utilizing its resources better every year. This highlights an increasing efficiency in operations.
Sometimes a company needs to take loans for its operations. This can be from a financial institution like a bank or NBFC or other entities. Being a loan, the company needs to pay interest on it.
This is the interest expense of the company. So, if a company has taken a loan of Rs.5 lakh at a rate of interest of 10% per annum, then it has an interest expense of Rs.50,000 every year.
This expense is deducted from the operating profit of the company. Therefore, in the example cited above, where the company has a revenue of Rs.5 lakh, expense of Rs.2.5 lakh, and an operating profit of Rs.2.5 lakh, the interest expense of Rs.50,000 is deducted from it operating profit bringing it down to Rs.2 lakh.
If the company does not have any debts, then this section will be zero. While assessing a company’s income statement, it is also important to see if the company’s debt is constantly increasing as this can impact its profits. Higher the debt – higher the interest expense.
Every profit and loss statement has a section called depreciation. Technically, depreciation is a non-cash expense. As the name suggests, depreciation means the reduction in the value of an asset over time. Companies have assets. Hence, the reduction in the value of the assets over time must be factored in as a notional loss.
From the example above, the company manufacturing t-shirts has machines that help them make t-shirts. Let’s say that the company purchased a machine for Rs.1 lakh with a lifespan of 10 years.
While there are many complex ways of calculating depreciation, for the sake of this example, let’s look at a simple calculation. Since the machine loses its value in 10 years, it depreciates 10% in value every year. Therefore, the depreciation of the machine will be Rs.10,000 per year. You need to deduct this amount from the profit.
Therefore, for the company in the example:
Operating Profit = Revenue – Expenses – Interest Expense – Depreciation
That is, 5 lakh – 2.5 lakh – 50,000 – 10,000 = 1.9 lakh
Since we are talking about a t-shirt manufacturing company, its primary revenue comes from manufacturing and selling t-shirts. Let’s say that this company also holds some other assets like a small piece of land.
It had purchased the land for Rs.1 lakh and sells it for Rs.1.2 lakh, making a profit of Rs.20,000 in the process. This income is the other income of the company. The reason it is called the other income is that it doesn’t come from its core operations. Therefore in the above-mentioned example, the profit if the company becomes:
Operating Profit = 1.9 lakh + 20,000 = Rs.2.1 lakh
Remember, this is ‘Profit Before Tax’ or PBT since the company has not paid taxes yet.
As an investor, it is important to pay attention to this segment. A fundamentally strong company is one that earns profits from its core business. However, there can be times when a company shows profits due to the other income avenues while its core business is suffering losses. This is a red flag.
If you see this in the income statement of a company, then ensure that you investigate further before investing.
The last segment that you need to factor-in is tax. Every company needs to pay tax on its earnings. Let’s say for the sake of the example that the company has to pay tax at the rate of 30%. Therefore, its tax liability is
Tax liability=(210000 x 30)100=Rs.63,000
Hence, the net profit is
Net Profit=210000-63000=Rs.1.47 lakh
As you can see, it is important to analyze the company’s profit and loss statement from top to bottom. This will give you a clear picture of how the company has performed at every step.
Assess the operating efficiency of the company by looking at its Operating Profit Margin. If it is increasing, then the company is becoming more efficient. Also, pay attention to the interest expense.
If it is increasing then assess where the company is utilizing the borrowed funds and if it is repaying its debts on time. Depreciation is also important since some companies tend to show lower depreciation to boost their profit figures. Hence, it is important to look at all the eight sub-headings mentioned above in detail.
Further, companies from different industries and sectors can have different headings and sub-headings. For example, a bank does not sell goods. Hence, its expenses are not the cost of goods sold but the cost of financing. Understand the core concept of an income statement and investigate every aspect carefully.
Disclaimer : The views expressed in this post are that of the author and not those of Groww.