Back to basics

The profit & loss account

Introduction

If you own shares, you'll remember that the company sends you a booklet called an annual report just before the annual general meeting. Most of the time, all you've done is admired the glossy pictures before adding it to the pile of newspapers for the raddiwala.

That's a pity, because a company's annual report can be a great source of information, helping you to decide whether to stay invested in the company. At the very least, it'll help you ask some tough questions to the management at the AGM.

We know the problem. You'll be thinking that's a lot of unreadable stuff! Not to worry, accountants are in business by making it difficult for ordinary people to understand accounts! All of us can learn to read accounts. We'll show you how.

The profit & loss account

At the heart of the annual report is the Profit & Loss Account. Accountants call it the P&L account to show familiarity, as well as to make it difficult for ordinary people to understand what they're talking about.

No company can exist for long by continuously making losses, and the P&L account shows the extent of profit or loss made by the company in a particular year. To illustrate, let's take the Reliance Industries annual report for 1998-99.

	1998-99		1997-98
	Rs.	Rs.	Rs.	Rs.
INCOME
Sales		14,553.26		13,403.78
Other Income		607.55		335.60
Variation in Stock		(152.43)		368.28
		15,008.38		14,107.66
EXPENDITURE
Purchases		190.32		14.19
Manufacturing and Other Expenses		11,500.52		11,206.93
Interest		728.81		503.55
Depreciation	1,776.66		1,460.27

Less : Transfered from General Reserve (Refer Note 3, Schedule 'O'){	921.62	855.04	792.95	667.32
		13,274.69		12,391.99
Profit Before the year		1,733.69		1,715.67
Provision for the year		30.00		63.00
Profit for the year		1,703.69		1,652.67
Add:Taxation for the earlier years		-		(85.67)
Balance brought forward from last year		1,047.89		662.79
Investment Allowance(utilised)		-		-
Reserve written back		-		36.00
Amount available for Appropriation		2,751.58		2,265.79
APPROPRIATIONS
Debenture Redemption Reserve	204.50		64.47
General Reserve	1000.0		752.65
Interim Dividend	23.39		10.33
Proposed Dividend	350.16		326.81
Tax on Dividend	40.86	1,618.91	63.64	1,217.90
Balance carried to Balance Sheet		1,132.67		1,047.89
Significant Accounting Policies
Notes on Accounts

You'll notice there are two main heads - income and expenditure. Simply put, the difference between the two is the profit (if income exceeds expenditure) or loss (if expenditure exceeds income). And losses, as you know, are bad.

Income

The total income is broken down into several heads-sales, other income, and variation in stock. Obviously, a company's sales will be its main source of income, so that item doesn't need much explaining. A source of confusion can be the fact that sales are sometimes called gross sales and at other times net sales. The difference is the amount of excise duty paid, and net sales is merely gross sales less excise duty. Net sales is a better indicator of how much the company is selling, because the excise duty goes to the government. Clearly, higher sales help the company earn higher profits.

"Other income" is accountantspeak for all those items of income which do not relate directly to the company's sales. This could include dividends and interest received by the company from its investments, the profit on sale of investments or assets, sale of scrap and other such items. Some companies put service income, like money earned by repairing or servicing, in this category. Basically, the thing to remember is that other income is very often, but not necessarily, income from activities distinct from the company's main activity. Sometimes such other income is one-off in nature, such as the profit from selling assets. So if you want to predict the company's future income, you'll have to leave out this kind of one-off income.

The third item, variation in stock, reflects the fact that a company always carries some inventory, which is nothing but unsold stock on a particular date. The company has already incurred some expenditure in producing this inventory, which is reflected in the expenses part of the P&L account. So the value of the closing stock should also be included to give the correct picture of the profit. However, from this closing stock the value of the stock at the beginning of the accounting period must be subtracted, since that was included as closing stock during the previous accounting period. That sounds complicated, but just remember that the variation in stock is actually nothing but closing stock less opening stock of finished goods and stocks in process. Why not raw material stocks? Raw material stocks are not included here because there is an item "raw material consumption" in the expenditure section of the P&L account.

Expenditure

The expenditure part of the P&L obviously has purchases and manufacturing expenses. In fact, all the costs that go into making the things the company sells. But that's not all. Interest costs incurred on the company's debts are also included here. Further, there's an item known as depreciation, which is nothing but a notional estimate of the wear and tear of the equipment used by the company. The logic is that a company needs to set aside a sum annually so that it can buy new machinery when it is needed. Clearly, keeping costs in check will add to the bottomline.

You'll notice that there's something known as schedules against the items in the P&L account. These are nothing but more detailed break-ups of these items. For instance, in the RIL P&L account, schedule L gives details of all the manufacturing expenses, such as salaries and wages, sales and distribution expenses, expenses on power, fuel, and administrative expenses like rent, insurance, etc.

Profit and EPS

Deducting expenditure from income gives the profit before tax. When the amount set aside by the company for tax purposes is deducted, we get the all-important net profit figure. Adding the balance brought forward in the account last year, we get the amount available for appropriation, which is nothing but the way the profit is divided. One chunk is paid to equity shareholders as dividend, one part goes towards paying dividend on preference shares, while the rest goes to statutorily required reserves, such as the reserve for redeeming debentures, and to the general reserve, which bolsters the company's net worth, or the amount of shareholder's funds.

A last word about EPS, which is earnings per share. This is a figure analysts love to talk about. EPS is calculated by dividing net profit by the number of shares allotted by the company. It shows how much each share of the company has earned during the year.

Also important is to check out the trends, by comparing last year's figures with those of the current year. Trends are important because they show the way the company is going. For instance, a company may still be earning profits, but the amount gets smaller and smaller each year. Nobody in his right mind would invest in such a company.

That wraps up the basics of the P&L account. Investors can use this information not only to find a company's earnings, but also how it has arrived at these earnings. Did sales increase? Were expenses kept in check? Was interest expenditure too high? The answers to these questions will be provided by reading the P&L account.