The Interpretation Of Profit And Loss Account
The main aim of this article is to discuss the various items in a profit and loss account of a business customer that a banker might wish to look at when assessing a lending proposition.
Our main discussion here will be on the information in the profit and loss account, and the analysis of such information.
Information In profit And Loss Account
The expected type of information in profit and loss account depends on the type of business that ia involved. A sole proprietor business will have a different type of profit and loss account that the limited liability company is operated on. Below is two different profit and loss accounts present for sold trader and also the limited liability company.
The Analysis Of A Profit And Loss Account
The first and foremost item to look for in any profit and loss account is the profit or loss for that particular period. If there is a loss, it gives a concern to the directors and management team but if there is profit, the concern of the owner now will be how big are the return. When analyzing profit and loss account, we must find out whether the profit or loss for that period shows a marked improvement or deterioration in results from previous times whether there is trend of rising or filling profits or whether annual profits are fairly constant.
It becomes difficult to judge whether profit is big enough or whether it is too small and therefore unsatisfactory? When the profit is too low, how do we identify the course of the problem? We may loan the ratio of some financial ratios like;
- The trend in profits and sales
- Profit and sales ratios: gross margin and net margin
- Cost and sales ratios
- The ratio of profit to the size of business
Profit Trend
One of the processes of analyzing profit and loss account is checking the trend by analyzing at least three years past financial records of the business. This will help you to measure the profitability as a percentage increase in growth or decline in profits from one year to the next.
A trend in profit is an indicator showing whether a business improving or deteriorating.
Profit and sales ratio, Gross margin and net margin: One way of measuring profit figure is the use of profit and sales turnover which is the profit margin.
Gross Margin: Is gross profit divided by sales multiplied by 100 percent. It is the difference between sales turnover and the direct cost of sales. It shows the size of the mark up for the business on the cost of goods sold.
Net Margin: Is the Net Profit divided by sales and multiplied by 100 percent. It is the profit margin that really matters most. For companies, Net profit is profit after tax but before divided. It is the bottom line profit figure when all expenses have been taken care of.
Based on all that has been discussed, a three years financial result from V-Cee Foods limited, they have been having Gross margin and Net Margin growth. There is an evidence of goods management and any lender could accept any proposal based on the three years ratio calculated. The trend analysis is not steady but might be as a result of changes in demand as a result of economic variables. Also based on the financial account of the company V-Cee Foods, for a period of three years as presented, the turnover had risen by 25% in the year 2006 and 24% in 2005.
However, the net profit fell by N8,000 in the 2006 and turned into a loss in the year 2005. The cause of this decline in net profit might be due to competition in the outlets, increasing cost of production and use of outdated machines. The management should look inwards to see what to do in improving the income of the income of the company.
Impact Of Proposed New Lending On Profit
The previous profit made in the past is a guide to any lending banker for any proposed new lending in the future. The impact of lending on profit could be discussed in two phases.
- If a customer wants the advance to expand the business, there is a strong possibility that gross margins will fall. To boost sales turnover, a business must often trim its selling price, and so the gross profit margin will be less. The effect on net margin of rising sales turnover will depend on how well the business can control its overhead costs, such as administrative and selling expenses, and how high interest charges will be.
- If a customer wants the advance to purchase a new fixed asset’s operational lie when it is not earning much in the way of sales turnover and profit. It might take time for the assets profitability to build up. Based on the foregoing it is left with the banker to check if the proposer would be able to meet up with its repayment schedule from the profits of the business operations. In summary, profitability ratios and other relative ratios on profit and loss account will be treated in more details in the next article.