The Profit and loss account is the financial statement of all transactions made by a company during a certain period of quarter or year. Profit and loss account expresses the revenue earned, expenses incurred, taxes paid etc. over a specific period of time which may be quarterly or annually. This statement must be scrutinized before making investment in any company. By analyzing profit and loss account you can be familiar with the health of the company, its depreciation, debt, or interest payment over a certain period either short term as well as long term. Profit and loss account reveals the company’s potential to deliver stellar performance. So, friends on reading this article you will learn how to analyse the profit and loss account of a company.
How to Analyse a Profit and Loss Account
In order to analyse the profit and loss account you need to know the components of profit and loss account of any company such as,
- Income or revenue
- Gross Profit
- Profit before tax
- Taxes Paid
- Net Profit
Now, let’s discuss about the above mentioned terms,
Income / Revenue
Income or revenue is the earning made by a company after selling its products or services. The income or revenue may be in cash or in credit known as trade receivables. The vital matter is what the source of income or revenue a company adopts. For example, Titan Company sells watches, jewellery etc. By selling these products Titan Company gets its income or revenue. Again let’s take the example of TCS or Infosys. They provide technical services or develop software and by doing so they create their revenue. This is their source of income or revenue.
Expenses is the money a company uses to produce some product or to run its business. However, there are many types of expenses a company has to incur. There are raw material cost, production cost, packaging, and transportation cost to produce a final product. Thereafter the company circulates the product across the country through transportation. The transportation cost is also treated as an expense. Again, if a company provides financial services and if the business is run in a rented house or commercial property, the rent is also treated as an expense.
Gross Profit or Operating Profit
The difference between income or revenue and expenses is the gross profit a company makes. You need to consider whether gross profit increases or not. If the gross profit increases quarter on quarter or year-on-year basis, it is a clear indication that the company runs the business well and it has a bright future.
Interest is the column which reveals how much amount a company spends as charges on its debts either in short term or long term. You should check whether the company looking to invest pays any interest. You should confirm whether the company pays off interest in increasing order. If the interest paid increases, there may be two possibilities. The first one is the company is trying to clear out the debt and it will be debt free in the near term. The second one is the company has a tendency to borrow money from the market. This indicates a clear signal of stay away from this type of company.
Depreciation is a reduction of valuation of a product or item. It may be anything plants, factories, furniture, machinery, cars, computers and many more. Depreciation takes place due to normal use and the course of time. Suppose, a company owns a machine which has provided proper services throughout the period. During the course of time, its productivity and valuation have reduced. This is depreciation. Now the machine will be obsolete in the future. There is much machinery which is subject to depreciation. You should focus on the depreciating assets or items of a company. As an investor, you should check the depreciating condition of machinery. It is wise to select such companies whose depreciation of machinery is low or very slow.
- Read also: How do I read and analyze an income statement?
- Read also: Profit and Loss Statement (P&L) – Investopedia
According to companies act, 1956 of Income Tax Act, a company is subject to pay income tax @30% of profit earned during any quarter or year. The company has to pay advance tax for every quarter. If the advance taxes are increasing then it is the clear sign that the company has delivered robust performance on a quarterly basis or year-on-year basis.
It is the difference between Profit before Tax and after paying the tax on any quarter or year. You must analyse whether net profit margin increases. In my opinion, if the Compounded Sales Growth is> 10%, Compounded Profit Growth is >15%, then it is the ideal company to invest in.
Now in order to pick such companies or stocks which has strong financial strength, you need to consider the following chart,
If you have any question regarding how to prepare profit and loss account or analyse the profit and loss statement of a company feel free to comment so that we have a discussion. If you found this post helpful don’t forget to share this post.