The remaining financial statement left to discuss is the profit and loss account, which can also be called as the income statement. I believe that this is justified because from my own observations I believe the objective of the profit and loss account is to show whether an organisation is making a net profit or not. In addition to this it also shows where this income is coming from and the important factors affecting it. And in the personal view of Thomas Ittelson it illustrates the health of the business by giving a true and fair reflection of an organisation’s financial affairs.
Michael Jones expands on my observations, by mentioning that a profit and loss account is used to record an organisation’s income and expenses and is prepared from information collected via a trial balance. He also explains why it can be called a profit and loss account and an income statement. The fact is that although they carry out the same purpose the difference between the two is actually based on the type of ownership the organisation has. The term ‘profit and loss account’ is used to define the income and expenses of a sole trader, whereas the term ‘income statement’ is used for listed companies. Although this is not passed as legislation, it is, however, a recommended practice by the International Accounting Standards Board.
An organisation’s main aim, no matter what industry it is within, is to make a profit. The amount of profit it makes (or doesn’t in the case of a loss) is often used to measure the overall performance of the organisation.
Michael Jones uses a quote of Sir Peter Parker from the Sunday Telegraph, where Sir Peter Parker compares profit as being just as important to the life of an organisation, as oxygen is to the life of a human being.
The two main factors that affect the profit of an organisation are its income and expenses.
The Oxford Dictionary of Finance and Banking defines income as being ‘a return that is measured over a given period of time’; and Gerald Klein (1995) defines expenses as being ‘money spent in the day-to-day operations of a business entity’.
Geoffrey Holmes Et al (2005) mentions that until today, four formats of profit and loss accounts have been used, of which formats 1 and 2 are single-paged as well as vertical, and are considered to be the most modern of the four; and formats 3 and 4, which are two-sided and are considered to be traditional. Although these traditional formats are nowadays very rarely practiced by UK listed companies, they were, however, quite common only 50 years ago.
Geoffrey Holmes Et al goes on to explain that format of the profit and loss account is structured in a particular way so that it can be conveniently divided into three parts to how much profit (or loss) was earned, how much was taken by taxation and what happened to the profit (or loss) that was left after taxation.
The format of the profit loss account is set up so that it flows from top to bottom, taking into consideration all income and expenses. Like the balance sheet, the profit and loss account also groups together its figures for presentation purposes.
A profit and loss account is usually prepared for monthly, quarterly and annual records. And would start at the top with the amount of turnover an organisation has achieved for the given period of time. The figure would be written as its net sales revenue, which James O. Gill defines as ‘the total value of all cash or credit sales less returns, allowances, discounts and rebates’.
Just as liabilities were separated for the balance sheet, the costs would also be grouped separately for the purpose of the profit and loss account. Costs would be separated into two categories, the first being the initial cost of sales and the second being any other expenses.
Thomas Ittelson defines cost of sales as being the cost an organisation records as the total cost of manufacturing a product and are normally found in businesses, which buy and sell goods rather than those, which provide services. This would include expenses incurred for purchasing the raw materials and any direct labour i.e. factory staff. All other expenses occurred during that period such as rent, wages and salaries, advertising, legal fees etc. would be categorised separately, as these are expenses that are incurred for developing and then selling the product, which would also include all administrative costs.
The profit and loss account would conclude its income and expenses in to figures, the gross profit and the net profit. The gross profit is a profit that is calculated by only taking into consideration the cost of sales. It is the difference left once the cost of sales has been deducted from net sales. It can also be called the gross profit margin as it measure how much an organisation makes for every £1 of its sales revenue. Net profit on the other hand is basically what is left over after the remaining expenses have been deducted from the gross profit. If the calculated sum is of a positive nature then the organisation would have made a profit, however, had it have been of a negative nature, then the organisation would have made a loss. Both the gross and net profit is used as method of measuring an organisation’s performance.
A point to mention is that although Thomas Ittelson agrees with Michael Jones’ perception that the profit and loss account measures the performance of an organisation, he also believes that it does not tell the complete picture about an organisation’s financial health.
Now that I have established what the main factors of the profit and loss account are, I can look into how these factors are used to create a financial picture of an organisation at a given period of time.
Just as like the balance sheet, the profit and loss account is also analysed and interpreted using ratios. Without using these ratios it would be extremely difficult to interpret what the profit and loss account is portraying.
The profit and loss account uses the information of income and expenses to determine how profitable the assets of an organisation are. Although there are a variety of ratios that could be used to interpret the information, in this case it would be best to use either the ratio for gross profit margin or net profit margin. Once again I will not go into too much detail of what these ratios mean, as I have gone into greater detail in the section of my exercises.
As the overall purpose of a product and loss account is to illustrate the amount of profit an organisation is generating, I will conclude my analysis by leaving you with a thought of what is meant by the term of profitability. According to The Oxford Dictionary of Finance and Banking, the term profitability is defined as being ‘the capacity or potential of a project or an organisation to make a profit’.
EXERCISE 1:
GROSS AND NET PROFIT
The table below is the profit and loss account of a mentioned organisation for the year 20XX:
The profit and loss account of the year 200XX shows that this organisation made a gross profit of £34,320. This means that this organisation had a gross profit margin of 74%, or in other words, means that retained £0.74 for each £1 of sales revenue received.
The profit and loss account also shows that during the same period in question, the organisation made a net profit of £19,100, calculating a net profit margin of 41%, which mean that the organisation made a profit of £0.41 for each £1 of sales revenue received.
I don’t think it is really possible to identify whether the wage bill is excessive or not as it would depend on a lot of factors, such as, the type of business, its opening hours etc. However, if I ignore such factors and compare it to the rest of the figures, my observations tell me that wages and salaries contribute to 70% of the total £15,220 expenses, which in my opinion this is quite excessive. My reason for this is that, in the theory section my research mentioned that expenses other then the cost of sales, are related to the development and selling of the product, this means that staffing that comes under this section would not be involved in manufacturing the product, but would instead be involved with selling the product, and may include activities such as advertising. And therefore I believe this could be reduced to leave the organisation with a greater net profit.
I don’t really see anything that alarms me about the stock levels. The figures show that the stock to start of with was quite low, when you consider that the organisation added an additional £18,000 worth of stock and only had £5,030 worth of stock left over. This shows that it may be the beginning of the season where the organisation is purchasing in large quantities. It could also be that the previous months were very good, and they could have forecasted based on those results that this month was also going to be just as good in terms of sales. And by buying extra stock this creates a comfort zone for the organisation.
EXERCISE 3:
REST ASSURED HAVEN
The table above shows profit and loss accounts from Rest Assured Haven for the year ended 30th September 2007 and also for the year ended 30th September 2008.
The profit and loss account of the year ended 30th September 2007 shows that Rest Assured Haven made a gross profit £684,185, less expenses of £569,891, gave the company a net profit of £114,294.
The profit and loss account of the year ended 30th September 2008 shows that Rest Assured Haven made a gross profit £729,192, less expenses of £674,510, gave the company a net profit of £54,682.
The differences between the years are shown in the table below:
The figures above show that even though Rest Assured Haven increased its gross profit by 6.58%, from £684,185 in 2007 to £729,192 in 2008, the organisation still some how managed to generate a net profit that was more than 50% less than of the previous year.
Increase in gross profit could have been anticipated due to sales increasing by 4.71%, from £983,585 in 2007 to £1,029,931 in 2008. But what I don’t understand is why the wage and salaries bill had to increase by 25% from £312,333 in 2007 to £390,416 in 2008, which obviously had a drastic affect on the net profit of the organisation.
As I have already mentioned in the theory section, my research illustrated that expenses other then the cost of sales, are related to the development and selling of the product, this means that staffing that comes under this section would not be involved in manufacturing the product, but would instead be involved with selling the product, and may include activities such as advertising.
Even though sales increased, there was only a minimal rise of 0.45% in cost of sales. So it doesn’t make sense that the organisation increased its staff to develop and sell the product, but didn’t make much of a change to the manufacturing staff even though production had been increased. I can only assume that this was a bad business decision.
EXERCISE 4:
HEALTHWISE LTD
The table below is the profit and loss account of Healthwise Ltd for the year ended 30th September 2007:
The profit and loss account of the year ended 30th September 2007 shows that Healthwise Ltd made a gross profit £330,000, less expenses of £200,000, gave the company a net profit of £130,000.
The table below is the balance sheet of Healthwise Ltd for the year ended 30th September 2007:
The balance sheet of the year ended 30th September 2007 shows that Healthwise Ltd had fixed assets of a value of £817,500, however, the company’s current liabilities of £770, 000 are greater than its current assets of £700,000. This means that it has a working capital of -£70,000.
The table below is the profit and loss account of Healthwise Ltd for the year ended 30th September 2008:
The profit and loss account of the year ended 30th September 2008 shows that Healthwise Ltd made a gross profit £275,000, less expenses of £135,000, gave the company a net profit of £140,000.
The table below is the balance sheet of Healthwise Ltd for the year ended 30th September 2008:
The balance sheet of the year ended 30th September 2008 shows that Healthwise Ltd had fixed assets of a value of £790,000, however, the company’s current liabilities of £710, 000 are greater than its current assets of £630,000. This means that it has a working capital of -£80,000.
Overview
Without going into too much detail, the two profit and loss accounts of Healthwise Ltd show that over the past year the company made a significant reduction in its gross profit, with it falling from £330,000 in 2007 to £275,000 in 2008. This is a fall of £55,000. It looks as thought this is largely down to a huge reduction in sales. In 2007 Healthwise Ltd had sales revenue of £500,000 and in 2008 this was reduced by £100,000 to £400,000. We can say that gross profit could have been even worse off had the company not have reduced its expenses.
However, even with all the reductions, Healthwise Ltd still managed to increase its net profit by £10,000 from the following year, from £130,000 in 2007 to £140,000 in 2008.
The two balance sheets of Healthwise Ltd show that over the past year the company reduced its fixed assets, from £817,500 in 2007 to £790,000 in 2008, a reduction of the value of £27,500. The balance sheets also show us that current liabilities have increased and current assets have continued to reduce. This has affected the working capital of the company, as it has been increased by £10,000, from -£70,000 in 2007 to -£80,000 in 2008.
Current Ratio
Current ratio is also known as the working-capital ratio. The ratio of the current assets of a business to the current liabilities, expressed as x:1 and then used as a test of liquidity.
For example, if the current ratio are £25,000 and the current liabilities are £12,500 the current ratio is 2:1. There is no simple rule of thumb, but a low ratio, e.g. under 1:1, would usually raise concern over the liquidity of the company. Too high a ratio, e.g. in excess of 2:1, may indicate poor management of working capital; this would be established by calculating the *stock turnover ratio and *debtor collection period ratio. Care must be taken when making comparisons between companies to ensure that any industry differences are recognised. The *liquid ratio is regarded as a more rigorous test of liquidity.
University of Oxford (2005) The Oxford Dictionary of Finance and Banking, Third Edition. Oxford, Oxford University Press.
Healthwise Ltd. 2007
Current Ratio = Current Assets
Current Liabilities
= 700,000
770,000
= 0.91:1
Relating the calculation above to theory from The Oxford Dictionary of Finance and Banking (2005), I can interpret that for the year ended 30th September 2007, Healthwise Ltd possessed current assets of a total value of £700,000 and held current liabilities of a total value of £770,000. This means that Healthwise Ltd had a current ratio of 0.91:1.
Healthwise Ltd. 2008
Current Ratio = Current Assets
Current Liabilities
= 630,000
710,000
= 0.89:1
Relating the calculation above to theory from The Oxford Dictionary of Finance and Banking (2005), I can interpret that for the year ended 30th September 2008, Healthwise Ltd possessed current assets of a total value of £630,000 and held current liabilities of a total value of £710,000. This means that Healthwise Ltd had a current ratio of 0.89:1.
Evaluation of Healthwise Ltd’s Current Ratio
Over the year the current ratio of Healthwise Ltd has decreased by 0.02, from 0.91 in 2007 to 0.89 in 2008. Although cash out goings were initially greater than cash in comings in 2007, what the current year figures show is that the difference between the current assets and current liabilities are widening. The Oxford Dictionary of Finance and Banking (2005) states that a current asset below 1:1 should raise concern over the liquidity of the company.
Quick Ratio
The quick ratio is more commonly known as the liquid ratio. The Oxford Dictionary of Finance and Banking (2005) defines liquid ratio as being a tool used to assess the liquidity of a company.
Healthwise Ltd. 2007
Quick Ratio = Current Assets - Stock
Current Liabilities
= 700,000 – 275,000
770,000
= 425,000
770,000
= 0.55 X 100
= 55%
Relating the calculation above to theory from The Oxford Dictionary of Finance and Banking (2005), I can interpret that Healthwise Ltd had £0.55 of liquid or current assts for every £1 of current liabilities for the year ended 30th September 2007.
Healthwise Ltd. 2008
Quick Ratio = Current Assets - Stock
Current Liabilities
= 630,000 – 140,000
710,000
= 490,000
710,000
= 0.69 X 100
= 69%
Relating the calculation above to theory from The Oxford Dictionary of Finance and Banking (2005), I can interpret that Healthwise Ltd had £0.69 of liquid or current assts for every £1 of current liabilities for the year ended 30th September 2008.
Evaluation of Healthwise Ltd’s Quick Ratio
Over the year Healthwise Ltd has seen a rise in their liquidity by 14 pence, from £0.55 in 2007 to £0.69 in 2008.
Although Healthwise Ltd has seen a rise in their liquidity over the past year, The Oxford Dictionary of Finance and Banking (2005) does state that a liquid ratio significantly below 1:1 should be seen as a concern. However, it also states that as there is no rule of thumb this could vary depending on the type of industry.
Gross Profit Margin
The gross profit margin is used as a tool to measure potential profitability per amount of sales revenue. An article found on Wikipedia (2009) describes this as a relationship between sales revenue and the cost of goods sold.
Gross profit margin is related to the net profit margin, which although contrasting, also assesses profitability, but only once fixed costs have been included.
Fdict (2009), a human edited financial dictionary, found online, explains that typical gross profit margin varies from one industry to another. The web site gives examples of legal services, banking, and software industries as having the higher gross profit margins, compared to grocery stores, petrol stations, and construction businesses as having the lower gross profit margins.
Healthwise Ltd. 2007
Gross Profit Margin = Gross Profit
Net Sales
= 330,000
500,000
= 0.66 X 100
= 66%
The calculation above shows that Healthwise Ltd made a gross profit of 66% for the year ended 30th September 2007, which means that the company would have retained £0.66 for each £1 of sales revenue received. Fdict (2009) states that this £0.66 that has been retained for each £1 of sales revenue could be used for paying overhead costs, administrative expenses, shareholder dividends, or other costs.
Healthwise Ltd. 2008
Gross Profit Margin = Gross Profit
Net Sales
= 275,000
400,000
= 0.69 X 100
= 69%
The calculation above shows that Healthwise Ltd made a gross profit of 69% for the year ended 30th September 2008, which means that the company would have retained £0.69 for each £1 of sales revenue received. Fdict (2009) states that this £0.69 that has been retained for each £1 of sales revenue could be used for paying overhead costs, administrative expenses, shareholder dividends, or other costs.
Evaluation of Healthwise Ltd’s Gross Profit Margin
Over the year Healthwise Ltd has seen a rise in their gross profit by 3 pence, from £0.66 in 2007 to £0.69 in 2008. According to Biz/ed (2009), a website designed for students and educators of business studies, this change took place as both cost of sales and wages we reduced.
Net Profit Margin
The net profit margin, like the gross profit margin, is also used as a tool to measure potential profitability per amount of sales revenue. The net profit margin, which can also be called the net profit ratio, defines the relationship between the sales revenue and the cost of goods sold. The only difference being between net and gross profit margin is that, the net profit margin is calculated by deducting all fixed costs, as well as the cost of sales from the sales revenue, whereas the gross profit margin is calculated by just deducting the cost of sales from the sales revenue.
Healthwise Ltd. 2007
Net Profit Margin = Net Profit
Net Sales
= 130,000
500,000
= 0.26 X 100
= 26%
The calculation above shows that Healthwise Ltd had a net profit margin of 26% for the year ended 30th September 2007, which means that the company made a profit of £0.26 for each £1 of sales revenue received, once the fixed costs had been deducted.
Healthwise Ltd. 2008
Net Profit Margin = Net Profit
Net Sales
= 140,000
400,000
= 0.35 X 100
= 35%
The calculation above shows that Healthwise Ltd had a net profit margin of 35% for the year ended 30th September 2008, which means that the company made a profit of £0.35 for each £1 of sales revenue received, once the fixed costs had been deducted.
Evaluation of Healthwise Ltd’s Gross Profit Margin
Over the year Healthwise Ltd has seen a rise in their profit by 9 pence, from £0.26 in 2007 to £0.35 in 2008. This was inevitable, as mentioned above; Healthwise Ltd reduced its cost of sales to increase its gross profit, which had an over all affect on its profit. Although the company also managed to reduce its fixed expenses, it did however, have to pay £10,000 more in taxes, which increased from £70,000 in 2007 to £80,000 in 2008. Had this not have been the case Healthwise Ltd could have made a greater profit margin.
REFLECTION ON LEARNING
The principles of finance in this module were aimed at enhancing and developing my already gained basic knowledge in the subject. The module was covered in such a way that it did not allow me to become confused by too much technical data and was allowed to progress at my own pace.
This module introduced me to the study of finance and provided me with enough depth and detailed knowledge to ensure that I understood the subject. Not only did the module improve my knowledge in the area, but it also allowed me to use what I learnt and relate it scenarios to solve problems and anticipate key business decisions.
The module focused upon developing my understanding in the key areas of finance, which are essential, no matter what industry I decide to take up a role in. This included interpreting prepared financial information, understanding the use of cash flow and budgets, as well as basic costing and pricing techniques.
I found the final stage most interesting out of the three, as it enabled me to really challenge myself when relating the theoretical aspects of the financial statements to the exercise I conducted. I also enhanced my knowledge by elaborating my understanding of key business terminology. This has helped me to understand a lot more about business finance, not only in class but also in my daily duties. I can now watch the financial programme on BBC News and understand exactly what is being said.
I understand that I have probably written more than I was supposed to for my theory, but I really do hope that this is something I don’t get penalised for. Throughout this assignment I have become more passionate about the topic and this passion forced me to look into a number of books to see how different authors view certain concepts of business finance.
APPENDIX A: READING LIST
Gibson, C.H. (2007) Financial Reporting and Analysis: Using Financial Accounting Information, Tenth Edition. Ohio, Thomson Higher Education.
P. 44-46, 87, 90, 92-93 and 135-138
Gill, J.O. (1999) How To Understand Financial Statements: Get to Grips with Profit and Loss Accounts, Balance Sheets and Business Ratios, Eighth Edition. London, Kogan Page Ltd.
P. 13-14 and 23
Holmes, H. & Sugden, A. & Gee, P. (2005) Interpreting Company Reports and Accounts, Ninth Edition. Essex, Pearson Education Ltd.
P. 118 and 120
Ittelson, T. (1998) Financial Statement: A Step-by-Step Guide to Understanding and Creating Financial Reports. New Jersey, Career Press.
P. 16-19, 21-24, 26, 30-31, 34 and 44
Jones, M. (2006) Accounting, Second Edition. Chichester, John Wiley & Sons, Ltd.
P. 2, 5, 76, 83, 89, 93-95 and 109
Klein, G. (1995) Dictionary of Banking, Second Edition. London, Pitman Publishing.
P.107
University of Oxford (2005) The Oxford Dictionary of Finance and Banking, Third Edition. Oxford, Oxford University Press.
P. 202, 239, 240 and 326
APPENDIX B: WEBSITES USED
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[Accessed on 27th March 09]
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