Financial Statements

• We will look at:– Income Statement (sometimes called Profit and

Loss Account)– Balance Sheet (latest terminology is Statement of

Financial Position)

Income StatementIncome Statement

• Start with Revenue – often called turnover.

• Cost of sales is mostly made up of raw materials used.

• Expenses are overheads, and selling and administration expenses

• Interest is net interest (interest paid minus interest received)

• Corporation tax is based on profits, currently 20% in the UK

• Dividends are paid to shareholders

Items £000 Revenue 1050

minus Cost of sales 500equals Gross profit 550minus Expenses 250equals Operating profit 300minus Net interest paid 10equals Profit before tax 290minus Tax 60equals Net profit 230minus Dividends 100equals Retained profit 130

Revenues

• Examples of quantity times price– Q3 2015 iPhone 47.5m times $660 = $31,400m!!– Toyota selling 8.7m vehicles in 2013 at $25,000 =

$217,000m• Revenue recognised when ownership has changed

hands, not when cash is received!

Cost of sales – variable costs

• Raw material costs– Toyota – steel, tyres, any materials/components

they buy– Tesco – cost of food or any product they sell

• Other direct costs– Workers on the production line

Expenses – direct costs

• These are the overheads. They are incurred whatever the level of output

• Salaries, rent, utilities, marketing, insurance, administration costs

The rest of the P&L• After gross profits we deduct other

costs, which are generally fixed costs:– Rent, utilities, marketing,

administration, selling costs

• This gives operating profit, a key measure of the performance of a business

• The next deductions are:– interest, arriving at profit before tax, – tax, arriving at net profit – dividends, arriving at retained profit,

which is added to the balance sheet

£000 Revenue 1050

minus Cost of sales 500equals Gross profit 550minus Expenses 250equals Operating profit 300minus Net interest paid 10equals Profit before tax 290minus Tax 60equals Net profit 230minus Dividends 100equals Retained profit 130

Some ratios

• We can calculate some ratios from the Profit and Loss account. These will be margins:– eg gross profit margin is

(gross profit/revenues) x 100– Operating profit margin is

(operating profit/revenues) x 100. This is my favourite of the profit margins

– Net profit margin is simply (net profit/revenues) x 100

£000

Revenue 1050

Gross profit 550

Operating profit 300

Interest 10

Profit before tax 290

Net profit 230

Gross profit margin 52.4%

Operating profit margin

28.6%

Net profit margin 21.9%

Profit quality

• What is profit quality• High quality profits are those which can be repeated. These

are profits from the normal course of business– If a company sells an asset and makes a profit on this,

profits are inflated for the year, and will not be repeated

– Of course a firm may make a one-off loss!

£m 2012 2013 2014

Revenues from operations 100 105 110Profit from sale of asset 0 15 0Costs 80 90 90Profits 20 30 20

Profit utilisation

• Means how much of the net profit is paid in dividends, or is kept in the business

• What are the advantages and disadvantages– High dividends means shareholder returns are

higher, so more investors might buy the shares• TSR = dividends per share plus change in share price

– However, if more of profits is paid as dividends, then less is retained in the business (retained profits), so this might mean slower growth

The Balance Sheet• Non-current assets

– Fixed assets like buildings

• Current assets:– Inventories means stocks– Trade receivables (debtors) are those who

owe the business money.

• Current liabilities– What the business needs to pay within 12

months– Trade payables (creditors) – those the

business needs to pay eg for supplies

• Non-current liabilities– Loans or creditors due after 12 months

• Equity– Share capital is the capital raised from the

sale of shares, eg 400,000 shares at £1– The rest is essentially retained profits (and

perhaps reserves)

£000Non-current assets: Land and buildings 550 Equipment 600 Total non-current assets 1150 Current assets: Inventories 300 Trade receivables 200 Cash 50 Total current assets 550 Current liabilities: Trade payables 250 Short-term borrowings 180 Total current liabilities: 430 Net current assets 120 Non-current liabilities: Bank loans 600 Total non-current liabilities 600 Net assets 670 Equity Share capital 400 Reserves and retained profits 270 Total equity 670

Balance sheet issues

• Working capital– It is important that a business has sufficient “liquidity” to meet day to day

expenses. This is working capital– Working capital is calculated as current assets minus current liabilities– If a firm does not have sufficient working capital it may need to sell fixed assets

= not good– We will look in more detail with ratio analysis

• Gearing– A Mr M favourite– How much of a firm’s capital comes from debt– Calculated as non-current liabilities divided by total capital (ie non-current

liabilities plus total equity) x 100– High gearing is risky, since an increase in interest rates could substantially

increase interest payments– Too low may suggest the business is missing growth opportunities

Balance sheet issues

• Depreciation– Depreciation is the decline in the value of assets– Assets do not last forever. For example a van costing

£15,000 may only last 5 years before a new one needs to be bought

– Depreciation takes this into account by:• Spreading the cost of the van over its lifetime, so allocating £3,000 (£15,000

divided by 5 years) as a cost each year, included in the income statement• Reducing the value of the van in the balance sheet by £3,000 each year

(though there is a corresponding asset)

– This means the costs of the asset are matched with the revenue it produces

Using financial data

• I may enjoy looking at financial statements, but what are they used for:

• Stakeholders (perhaps owners and directors in particular) use them for a number of reasons:– To compare performance with competitors

• Is profitability higher than competitors

– To compare performance within the business (between different products or business lines, or between different geographies)• Which Tesco stores are the most profitable, is the iPad more profitable than the

iPhone

– To compare performance over time• Are profits growing etc

– To help management make decisions• What can the firm afford to do, should a branch be closed

Strengths and weaknesses of financial data

• Can we trust the data?– We should be able to nearly all the time

• All financial statements have to be approved by an external auditor (accounting firm)

– But there are occasional blips• Tesco is reported to have overstated revenues as a result of early

recognition of rebates from suppliers (complicated topic)

– And there is room for manoeuvre “Window Dressing”• Firms and their accountants do have some freedom in the choice of some

methods of accounting which can make a difference to published accounts• For example a firm may choose a method of depreciation depending on

whether it wants reported profits to be higher or lower• But these decisions can mostly be seen in the reports and accounts