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Women's Weekly : 3 key factors influencing profit and loss - Views on News from Equitymaster
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  • Sep 10, 2009

    Women's Weekly : 3 key factors influencing profit and loss

    Once upon a time, in a land far far away, there lived two children, called Hansel and Gretel. Their evil step mother devised various ways of abandoning them in a dense forest. She hoped that the children will lose their way in the forest and never return back.

    The children however, always found their way back. Whenever the children left for the forest, they carried shiny pebbles from a pond with them. These pebbles shone like diamonds in the night sky, their glow like a beam of light in the pitch dark night, marking the way back home for the children.

    The children later grew up. Hansel became an investment banker. Gretel got into advertising. When they met up for coffee one day, Gretel told Hansel that she found that the world of annual reports of a company resembled the confusing forest of her childhood.

    Hansel then told her that she had to apply the same principles of having pebbles or landmarks in order to manoeuvre through the reports. He told her that she would find all the necessary pebbles in the Profit and Loss statement of the companies.

    Soon, Gretel, understood the nuances of equity investment and before long, Hansel was coming to her for advice. In this issue of women's weekly, we will share with you those landmarks that Hansel outlined for Gretel to understand the company annual reports better.

    The first pebble was called: 'Top line Growth'

    Before investing, one must always pay attention to a key factor such as the Profit & Loss statement of a given company, especially over a time period of the past 5 years.

    The Profit and Loss statement of a company gives a clear view of what the topline growth of a company is. The first thing that you will notice in the Profit & Loss statement of a given company is the top line, which is the net sales of the company.

    The top line is the actual earnings of the company-the revenue that is generated by the core activities of the company. If the company was a cricketer, the income earned by playing cricket would be the actual earnings of the player; money from ads would not come under actual earnings.

    Thus the net sales or the top line of the company are the revenues generated by the primary activities of the company, after discounting the allowances and deductions based on actual sales.

    Thus, when studying the topline of a company, what needs to be looked at is the kind of growth that the company has clocked in the past and the potential to grow in the future. The latter will depend a lot on the sector in which the company is operating in and the kind of competition that it is witnessing.

    Also, the growth expected should be viewed in context of the size of the company. Thus, a small sized company is likely to grow at a faster pace than a big company with sizeable revenues as the former is still in the growth phase. This does not necessarily mean that one should not invest in the bigger company as there are various other factors that need to be considered before making that decision.

    The second pebble was called: 'Operating profit margins'

    Next in line come the expenses of the company. To run the business on a daily basis, any company will have to incur nominal expenses. These expenses are termed as 'expenditure required for normal business transactions'. Cost of raw material (material costs), the salaries of the employees (personnel costs) etc are examples of such expenses. These are largely termed in financial jargon as operating expenditure.

    So how do we determine the profits based on this? SIMPLE!

    Operating profits = net sales - operating expenditure

    Technically, operating profit margins can be defined as the operating profits that a company generates from its core operations as a percentage of sales. Operating profit margins are thus actually a percentage of net sales or the topline growth.

    Understanding the operating margin of a company over a given period of time is essential as it enables you to determine the quality of the company's business in terms of how much profit it is able to generate from its core business. If a company's margins are high, it acts as a cushion in covering further expenses.

    The third pebble was called: 'Net Margins '

    The net earnings of the company are nothing but profits left after all the expenses including taxes have been paid. Net earnings are also called net profits or bottom line.

    To better understand the profits made by the company, another key factor one must review in the P&L statement is the Net Margin, as it determines the net profit as a percentage of the revenue earned. For example if there is a company making a chocolate which it sells for Rs.10 (Revenue), and the cost to produce it is Rs.6 and they pay an additional Rs.2 as taxes, then the net income would be Rs.2 (i.e. 10 - 6 = 4; and 4 - 2 = 2). Therefore the net profit margin would be 20% (net income / revenue x 100)

    Net margins will vary from company to company as well as industries. This is because expenses of different companies are different. Therefore, the net margin of a company enables comparison between other companies easily. Hence, a low profit margin would indicate a lower level of safety for investors.

    Expenses also include other key factors such as interest costs. This would be compensation paid to the banks for using borrowed money. The company also has to set aside a part of its profits towards asset replacement as assets wear off over a period of time and need maintenance. This is called as depreciation.

    As an investor you should be aware that the interest cost ratio determines the credit risk of the company in the market. This means that the company should not have taken too many debts or loans. If it has any debts then it should have the capacity to repay those borrowings or loans in the stipulated time frame. Only then the stocks of the company can be considered as a safe bet.

    The interest coverage ratio is calculated by dividing the company's earnings before interest, by its interest expense for a given period.

    Interest coverage ratio = earnings before interest and taxes

    Let us consider the example of the chocolate company once again. The company has made an earnings of Rs.1,200 ( before deducting interests and taxes), and it has a loan of Rs.100 at an interest rate of 10% p.a. (i.e: Rs. 10). Hence, the interest coverage ratio of the company will be calculated as:

    Interest coverage ratio = chocolate company's earnings before interest and taxes
    = 1,200
    = 120

    As the interest coverage ratio is high (120), this chocolate company would be a potentially good investment.

    In order to become a wise investor it is essential to familiarise yourself with the two most important financial statements for investors - the P&L statement and the Balance Sheet. In this article we have touched upon the key essentials in the profit and loss statement which you should have a good understanding of in order to gauge the profitability of the company. In the next article we shall touch upon the basic things one should look at in the balance sheet of the company.



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