At its very core, any business is essentially management of money .The language of money is finance. Therefore it is important for all practicing and budding managers to have a working knowledge of the financial statements. This will help them deal with the finances of the Corporates better. The present article seeks to introduce financial statements and cover the profit & loss (P & L) statement in detail. Let us start by understanding the role of financial statements.
Q1) What is the role of financial statements?
Ans. Financial Statements play an important role as they give a picture of the state of the business. There are primarily three main financial statements. These statements are:
a) Profit & Loss Statement.
b) Cash Flow Statement.
c) Balance Sheet.
The study and analysis of each of these statements reveals three important dimensions of the business.
Q2) Which are the important business dimensions that financial statements indicate?
Ans. The Profit& Loss statement (P & L) indicates the profitability of a business. The Cash Flow statement is equally important as it indicates the liquidity position. Finally the Balance Sheet statement indicates solvencyof the firm.
| Details of Financial Statement | Business Dimension Covered |
| Profit & Loss | Profitability |
| Cash Flow | Liquidity |
| Balance Sheet | Solvency |
Q3) Why is the P& L statement important?
Ans. As we are aware, the fundamental purpose of any business is to make profits.The P&L statement is important as it indicates the profitability of the unit. It broadly indicates the income earned and expenses incurred by the business entity over a period of the time. The P & L statement captures all the business activities during aspecified period. In case of MNCs this period could be a calendar year (Jan to Dec). In case of Indian companies this period is thefiscal year (April to March).
Q4) What is the starting point ofthe P & L statement?
Ans. The revenue or Income generated is the starting point of P&L. The revenue earned is therefore called as Top-line as it appears on the top of the P & L statement. A firm can earn revenue either through its core activities or by way of other income.A good blue chip firm should show consistent growth in its value driver that is the core income of the firm.
Q5) What is core income of a firm?
Ans. The core income of a firm is the income earned from the basic activities,for which the firm was formed. These activities are as defined in the financial charter of the firm. In India the financial charter is known as Memorandum of Association (MOA) and Articles of Association (AOA). An easy way of identifying core activities of a firm is to note that the incomes from these activities are normally recurring in nature. This is not the case with other income for a firm.
Q6) What is other income for a firm?
Ans. As the name indicates, other income is the income earned from activities other than the basic core activities. It is to be noted that other Income is normally non-recurring and is often one time income. A classic example of other Income is the income received by a manufacturing firm on sale of its real estate. This is obviously an one time income for a manufacturing firm. On the other handsale of real estate would be core income for a real estate company as it is their core activity.In order to arrive at profitability one should deduct the expenses incurred from the income of the firm.
Q7) What are the various expenses incurred by the firm?
Ans. The expenses incurred by the firm can be broadly classified as:
a) Production Expenses.
b) Administration Expenses.
c) Selling & Distribution Expenses. (S&D )
d) Research & Development Expenses. (R&D)
e) Miscellaneous Expenses.
It is important to analyse each expense in detail as it will help in understanding the cost drivers of a firm.
Q8) What are the cost drivers of a firm?
Ans. In general, it is found that20%of expenses in number, constitute 80% of total costs in value of the firm. Such main expenses which are small in number but contribute significantly to the total costs are called as cost drivers. For example in IT firms, expenses on salaries and wages are significant and thus are itscost drivers. On the other hand, in manufacturing units, expenses on raw materials and power are significant and thus will be its cost drivers.In case of FMCG companies, Selling & distribution (S&D) expenses could be one of the cost drivers. The identification of cost drivers helps in Strategic Cost Management.
Q9) What is Strategic Cost Management (SCM)?
Ans. SCM aims at improving the competitive ability of the firm by reducing costs significantly without affecting the quality. SCM is important as it helps in effective cost management and control. Depending on the cost drivers one can decide on cost management strategy. For example,ferro- alloy manufacturing firms will be benefitted more by reduction in power & raw material costs than by reduction in labor costs.On the other handIT firms may benefit more if manpower costs are reduced.When these basic expenses are subtracted from Income we get a measure known as EBITDA.
Q10) What is EBITDA? How can EBITDA be analysed?
Ans. EBITDA stands for Earnings before Interest Tax Depreciation & Amortisation. EBITDA is critical for business analysis. If EBITDA of a firm is negative, it shows that it isearning an income which is not even sufficient to cover its basic expenses.Such a precarious financial condition cannot continue for long and if this situation persists, eventually the firm will end up in bankruptcy.An apt example will be that of the new Indian telecom companies which had recently acquired licenses. Many of them had negative EBITDA due to which eventually they had to shut shop.
The first requirement for any business unit therefore is to be positive at EBITDA level. This is because apart from basic expenses there are other operating expenses like D & A expenses which need to be recovered subsequently.
Q11) What are D & A expenses?
Ans. D & A stands for depreciation and amortisation. Depreciation accounts for the loss in value of assets such as machinery due to wear & tear. It can also be defined as the loss in value of assets due to obsolescence and passage of time. It needs to be noted that charging depreciation expenses i.e. reducing income by depreciation, every year helps in setting aside funds for future replacement of assets. Amortisation is same as depreciation with the difference that depreciation is applicable for tangible assets while amortisation is for intangible assets. It is important to note that that D &A expenses are different from other operating expenses.
Q12) How is D & A different from other operating expenses?
Ans. Unlike other expenses, D & A is a non cash expense as it is not paid out by the firm.For example wages are paid out by the firm. Similarly raw material charges, advertising expenses are paid by the firm. However the firm never pays D & A expenses to any entity. Thus D & A expenses are non cash expenses.
When D & A is subtracted from EBITDA, we arrive at Earnings beforeInterest (EBIT). EBIT is also called as Operating Income. From EBIT we should subtract financial expenses.
Q12) What are these financial expenses?
Ans. Financial expenses are primarily interest charges. Interest is the servicing costs on the loans taken by the company. The amount of loans taken by the firm is influenced by the financing policy adopted by the firm. It needs to be noted here that some firms reduce the interest they receive on their investments, from the interest they pay on their loans. The figure thus arrived at is called net interest. Apart from the net interest, financial charges also include commission, processing fees etc. When these financial charges are subtracted from EBIT we arrive at Earnings before Tax (EBT). From EBT we deduct the statutory expenses.
Q13) What are these statutory expenses?
Ans. Taxes are the main statutory expenses. These are basically direct corporate taxes to be paid by the firm. In most countries firms have to pay corporate taxes on their earnings (also called as profits). In case of India the tax rate is about 33%. However if a firm plans its tax policy well, it can substantially reduce its tax burden. For example many Indian companies have an effective tax which is far lowerthan 33% due to good tax planning. When taxes are subtracted from EBT we arrive at Earnings after Tax (EAT).
Q14) Why is EAT significant?
Ans. EAT is final line item in the P & L of a firm. It is also called as earnings. Often it is also called as bottom line as it appears at the bottom of the P & L statement. EAT is significant as it represents profits earned by the firm, which belongs exclusively to the owners i.e. shareholders.The firm can either distribute it as dividends (hence dividends are called as distributed profits). The firm also has the option to plough the profits back into business as internal accruals.Firms normally follow a mixed dividend policy. They distribute part of profits to shareholders as dividends and retain the balance earnings to plough back into the firm for future growth. In India EAT is commonly known as Profit after Tax (PAT) or Net Profits.
| Format of P & L (Profit & Loss Statement) | |
| INCOME | |
| Less | Expenses |
| EBITDA (Earnings Before Interest, Tax, Depreciation & Amortisation) | |
| Less | D & A (Depreciation & Amortisation) |
| EBIT (Earnings Before Interest and Tax) | |
| Less | Interest |
| EBT (Earnings Before Tax) | |
| Less | Tax |
| EAT (Earnings After Tax) | |
Sales Volume is Vanity
Profit is Reality.
Cash is Sanity.
First milestone: Be EBITDA positive as fast as possible.
Second Milestone: Once EBITDA positive, try and achieve break even quickly.
Note: Breakeven is a no profit no loss situation and it accounts for all the expenses
Third milestone: Operate above breakeven point so as to earn profits. Once the firm earns profits, concentrate on reducing the payback period.
Note: Payback period refers to the period within which the invested capital is to be recovered.