Financial Statements: Understanding Profit and Loss Account (Income Statement)

This is in a series of articles that will highlight the process of fundamental analysis. In this section, we will talk about a financial report called “Profit and Loss Account” (P&L Account).

Profit and loss account is also known as income statement. It is a document which is prepared by the company to report its income, expense, and profit happened in last 12 months. 

P&L account talks about few important things about the business. First of all it talks about how much income the company has generated in last FY (12 months). In India the financial year of a business generally starts from first of April and ends on 31st of March. So when P&L account is prepared it is prepared for a period between 1st of April and 31st of March.  

The next important thing that profit and loss accounts states is various expenses that the company has incurred in the last FY. 

Once the income and expense line items are listed by the company, the next important deduction that is made is called the gross profit. By adjusting depreciation, interest expense, and tax expense, net profit (PAT) of the company is deduced in the P&L account. 

Statement of Profit and Loss Account

This is the snapshot of how a typical profit and loss account looks like. As a beginner one must first try to grasp the structure of this report. How it is structured? It starts with stating the income of the company. Next it lists down all expenses of the company. Then what will come is profit before tax (PBT), tax liability, and net profit (PAT).

In this article we will see in detail these components of profit and loss account. Let’s start with the income…

Income (Revenue)

In the profit and loss account of Tata Steel, “Total Income” component of the company is represented as (a) Revenue from operations, and (b) Other income. In FY ending 31-Mar’20, the company’s total income was Rs.60,840.09 Crore, out of which Rs.60,435.97 Crore is from operations and Rs.404.12 Crore is from other sources. 

The details of these income heads is provided in the Notes SL 27 and 28. Hence if one wants to know a further break-up of revenue from operations or other income, they must look into these Notes. “Notes” form an integral part of financial statements.

Let’s look at the notes SL No 27 and 28. 

Note No 27 provides a break-up of ‘Revenue from operations’. Here we will get to know what the company means by operation income. For Tata Steel it is sale of products, sale of power and water etc.

Sale of products (Steel) has fetched Rs.57,167 Crores. Sale of power and water has fetched Rs.1,647 core. The company has also classified Rs.1,620 Crore worth of income as “other operating revenues”. 

Note No 28 provides a break-up of “Other Income” sources. For Tata Steel other income is dividends, interest, change in value of investments (mutual funds), sale proceeds of capital assets, etc.

Other income accounts for Rs.404 Crore. Out of this Rs.89 Crore is dividend income. Rupees 73 crore is interest income. Rupees 98 crore is from sale of investments like mutual funds Rs.147 crore is also accounted as “other miscellaneous income”. 

Expenses (Revenue)

Now we will look at the company’s expense statements. First we will look at the absolute numbers then at their respective notes. Company generally classify their various expenses into few expense heads. So first thing we can look here is, what are the expense heads of the company.

Generally speaking, depending upon the type of business, similar company will have similar expense heads. Like expense heads of manufacturing company’s (like steel cement, auto, oil and gas etc) will be alike. 

#1: Cost of material consumed

The first expense head of Tata Steel is ‘Cost of material consumed’. This expense head has consumed Rs.17,407 crore for Tata Steel in FY ending 31-Mar’20. Unfortunately, I did not find any associated notes against this expense head. As an analyst, I would’ve loved to know more about which are the “materials consumed” and in which proportion. 

#2: Purchase of stock-in-trade

The second expense head is ‘Purchase of stock-in-trade’. This line item has consumed Rs.1,563 crore in FY 2019-20. But again the company has not provided any break-up of this items.

Though purchase of stock-in-trade means all those items with company purchases as finished goods. These are purchased and sold by the company without further any processing. Remember these items are not raw material for the company. They can either be finished goods brought forward in current year from last year’s inventory, or traded items.

#3: Changes in inventories of finished and semi-finished goods, stock-in-trade and work-in-progress

The third expense head is “Changes in inventories of finished and semi-finished goods, stock-in-trade and work-in-progress”.  This expense head is calculated by noting how much inventory, WIP, stock-in-trade was there at the beginning of the years and end of the year. For Tata Steel, in FY2019-20 this value was in negative (Rs.564 Crore). To understand more about this expense head, let’s look at its note no 29. 

There are three types of inventories for the company: (a) Work in progress: those raw material or items which are taken from stores but has not reached the finished goods storage bay. They are still under operation. (b) Finished Good are ready for sale products. (c) Stock in trade. 

In this case you can see that inventories at the end of year (Rs.4,783 Crore) is more than Inventories at the beginning of the year (Rs.4,219 Crore). It means the company has produced more than it has sold. Hence the value of “change in inventory” is shown as negative (-Rs.564 crore) in expense head. 

#4: Employee benefit expenses

The fourth expense head is “Employee benefit expenses”. Under this expense head, items like salaries paid to employees, provident fund contributions, and staff welfare schemes are listed.

This becomes more clear when we will see the note no 30. You can see that the salaries and wages costs Rs.4,231 Crore. Contribution to PF is about Rs.477 Crore, and cost of welfare scheme is Rs.328 crore. 

#5: Finance Cost

The fifth expense head is classified as “Finance Cost”. Under this head the cost to Tata Steel was Rs.3,031 crore. This is cost incurred by the company when it borrows funds.

The borrowed funds can be bank loans, debt from financial institutions, bonds, credit lines etc. The interest paid to the lenders on the borrowed funds is classified as finance cost. Note 31 provides more details on the finance cost. 

#6. Depreciation and Amortisation

The sixth expense head is “depreciation and amortisation expenses”. For Tata Steel this cost is amounting to Rs.3,920 Crore. This is just an accounting adjustment and may not represent the actual cash outflow. It is important for analysts to understand the concept of depreciation. Details of the cost booked under Depreciation and amortisation can be found under note no 32.  

What is depreciation? It is an accounting method to book cost of an asset as an expense not in one go but over time. 

Example: Suppose a company has a net profit of Rs.10 Crore. It buys a machine (asset) costing Rs.15 crore in year 2020. The expected life of the machine is say 5 years. In this case if the company books the total cost of machine (Rs.15 crore) in year 2020 itself, its net profit will go in negative (10 crore minus 15 crore).

Hence, instead of booking all costs in one year, the company is allowed to depreciate its asset over next 5 years. It means, each year the company can book Rs.3 crore (Rs3 crore x 5 years = Rs.15 crore). 

P.Note: Depreciation is for tangible assets. Amortisation is for intangible assets. 

#7: Other Expenses

The seventh and last expense head is “other expenses”. All expenses which does not fall under the above six heads is booked under this head. For Tata Steel this expense line item had a cost of Rs.23,803 crore. It is a biggest expenses head for Tata Steel.

Generally speaking, when I see such high costs booked under “other expenses” head I do not feel comfortable. Though details of other expenses are provided by the company under note no 33.

Total Exceptional Items

When the company generates some income or expenses on account of such activities which are not typical, it can be listed as exceptional items.

In case of Tata Steel, in FY 2019-20, cost booked under exceptional items is Rs.1,703 Crore. An explanation of all these costs as been provided in the note no 34. 

Profit Before Tax (PBT), Tax Liability, and Net Profit (PAT) 

What we have seen till now is the list of all incomes forming the “Total Income” of the company. We have also seen list of all expenses forming the “Total Expenses” of the company – including exceptional items. 

Subtracting total expenses from total income as calculated above will give us “Profit Before Tax”. For Tata Steel, Profit Before Tax number is Rs.6,610 Crore. 

Income tax liability for the company in FY 2019-20 is -132 crore. Why tax liability is negative? Because the company has decided to opt for deferred tax by an amount of Rs.1,920 crore. 

I’m not sure what was the reason behind opting for deferred tax, but this is again something which does not make me comfortable about the company. 

As the company has gone for deferring their tax liability, their net profit after tax (PAT) is amounting to Rs.6,743 crore which is higher than PBT. [PAT = PBT – Tax Liability]

Conclusion

We have gone through the total profit and loss account of Tata Steel in totality. It may be possible that by just looking at the line items in P&L account, you may not get full clarity. Hence it is always advisable to also look the associated notes.

In this article, what we have seen is “how profit and loss account of a typical company is structured”. The financial statements of banks are formatted differently. If you will follow the structure explained above, you will also know “how to read” this report in a free-flowing manner.

But reading the report in only one part of it. As an analyst, one must also make meaning out of the published numbers. This we will learn in the chapter of financial ratio analysis.

Alternatively you can also refer our excel based tool which can do the fundamental analysis of companies with click of few buttons. Please read more about it here.

But before that lets learn about how to read balance sheets of companies.