Analysis of Operating Statements

2. The requirements as to profit and loss account are indicated in Part II of Schedule VI of the Companies Act. It shall be made out as clearly as possible to disclose the result of the working of the company during the period covered by the account and shall also disclose every material feature relating to the income and expenditure of the company arranged under the most convenient heads. The corresponding amounts for the immediately preceding financial year for all items shown in the profit and loss account shall also be given in the profit and loss account.

3. The profit and loss account for a given accounting period may be conveniently divided into three portions as under:

a) Manufacturing Account

b) Trading Account

c) Appropriation Account.

All these three accounts may not be maintained as some manufacturers may combine the manufacturing and trading accounts, while companies conducting only trading activities may not be having a manufacturing account. After the profit has been established by the operations recorded in the manufacturing and trading account, it is usual to transfer the balance to an appropriation account, from which appropriations are made to Taxation provision, General Reserves and provision for dividends. The profit and loss account forms the connecting link between opening and closing balance sheet dates.

4. A clearer picture for purposes of analysis would emerge if the profit and loss statement is divided into following distinct groups :

a) Total sales and other income

b) The cost of goods sold

c) The gross profit

d) Selling and distribution expenses

e) Administrative expenses

f) Net profit/loss

Classification of the profit and loss items in the above manner, facilitates evaluation of structural relationships i.e. the proportion of the component parts such as cost of goods sold, selling and distribution expenses and administrative expenses to total sales. Preparation of Profit and Loss statements on a similar basis for a number of years enables evaluation of trends, i.e. movements in the various comparable groups from year to year.

5. Keeping these observations in view, all profit and loss statements may be classified and set down for comparison and study in the following manner.

These are the profit and loss statements of a manufacturing concern classified as suggested above for three consecutive years. By arrangement of the figures in the like manner and equating each year sales to 100, the cost of goods sold as percentage of sales, gross profit as percentage of sales, selling and distributing expenses as percentage of sales and lastly administrative expenses as percentage of sales have all been calculated and recorded. Reducing the expenses as percentage of sales will enable comparisons to be made as to how the expenses have fared in the context of the rising and falling trend in sales. In the above analysis, a steady fall in sales year by year may be noted, and in the context of this fall, a steady rise in the cost of goods may be perceived. The increase is about 4% a year and the basic factors that have contributed to this steady rise should be a major factor determining the quantum of profits that would emerge. Similar remarks will apply to the items also, which on the whole will enable the reader's mind to make a detailed comparison constituting the different outgoings and enables study of the underlying trends.

The use of percentages in analysis of operating statements is subject to following limitations :

(a) Sales realisations might appear increased or decreased owing to a rise or fall in selling prices.

(b) Any alteration of one group is accompanied by alterations in another group - as the total of all percentages should be 100.

Inspite of the above limitations, the percentage comparisons usually give a clearer picture of the basic trends underlying the changes, than comparison of absolute amounts.

7. The basic trends that cause fluctuation in profits may be summarised here for purposes of investigation, as follows :-

(a) A rise or fall in sales level and its effect on net profit.

(b) A rise or fall in sales in relation to total funds employed.

(c) Maintenance of a reasonable steadiness in the percentage of cost of goods sold to sales.

(d) A rise or fall in gross profits.

(e) Changes in percentage of selling expenses in relation to sales.

(f) Changes in percentage of administrative expenses to sales.

(g) Changes in net profits.

A proper evaluation of these changes over a period of years would give valuable information about the progress of a company and would be of some assistance for a Banker for discussing business problems with proprietors or Directors of enterprises.

Increase or decrease of factory efficiency resulting in increase or decrease in volume of production, increase or decrease of gross margin by increase or decrease of selling or manufacturing costs are all important positions about the actual working of the company and these are reflected in the profit and loss statements.

It is therefore necessary that the figures given in the profit and loss statements be properly classified and compared year by year to enable drawing financial inferences.

While the changes in the yearly Balance Sheets indicate changes in the quantum and nature of assets held and the nature of funds employed for such holding, the changes in the profit and loss accounts, indicate the changes in the results obtained from the application of those funds and utilisation of those assets.

8. An analysis of the income and expenditure account may be made in the following manner.

1. Sales

2. Closing stock of inventory and work in progress

3. Opening stock of inventory and work in progress

4. Value of production ( 1 + 2 - 3 )

5. Other income, if any

6. Total income (4 + 5)

Expenditure

7. Raw materials consumed and other manufacturing expenses

8. Salaries, wages and other benefit to staff

9. Selling expenses

10. Depreciation

11. Administrative expenses

12. Total expenses (7 to 11)

13. Profit before tax and interest (6 -12)

14. Interest

15. Tax provision

16. Profit after tax and interest [13 - (14 + 15)]

17. Dividend

18. Retained profits (16-17)

9. Any profit and loss account may be recast in this particular form and certain changes taking place in the cost structure and efficiency in the use of funds may then be evaluated.

I. On the cost structure :

(a) Raw materials used and other manufacturing expenses as percentage of production - i.e 7/4 x 100. Changes in this percentage year by year indicates rise or falls of manufacturing costs of a given volume of production.

(b) Total expenses as value of production - i.e. 12/4 x 100. Changes in this percentage year by year indicates rise or fall of total expenses as percentage of a given volume of production.

II. Efficiency in the use of funds :

(a) Value of production as percentage of net worth - i.e. 4 / T.N. W. x 100. Changes in this percentage indicates the increase or decrease in the efficient use of funds, or increase or decrease In Management efficiency.

(b) Value of production as percentage of total net assets. Changes in this ratio indicates also the efficiency in the use of funds and management. In both these cases greater the production. In relation to net worth or total capital employed, greater financial efficiency may be presumed.

This analysis helps any entrepreneur to correct any regressive trend in the working of any enterprise under his care and for a Banker, helps to have real inside knowledge about the working of the enterprise, to arrive at right lending decisions and discuss company problems with entrepreneurs in an effective manner.

10. The above should be sufficient to enable analysis of any profit and loss account for drawing simple financial inferences useful to a Banker for evaluation of the financial strength and earning capacity of any enterprise. The profit and loss account is also considered in the context of net infiow and outflow of cash and a result of operations. This aspect will be discussed in a note titled "Cash flow". It is also considered in the context of a "Break even point" at which level of production the enterprise will just meet its working expenses or make a no profit or no loss position. This aspect would be discussed in a separate note entitled Break even analysis.