How to read the profit and loss account

We've already done part one, which was looking at where to get some of these vital information. Now to really start digging a little bit deeper and look at the profit and loss account. One of the three key parts of a set of detailed company accounts. Now, before we go any further, please just take a few precious seconds to look at this all important disclaimer.

Thank you for studying that. So let's move on to the Profit and Loss account. Or to use the jargon, the PNL. Okay, so again, we've already discussed this before in the first video, but let's go through it again because it's really important. A set of accounts will have three parts the PNL or profit loss account, cash flow statement, and the balance sheet.

And they have to be found on the Regulatory News Service, which you can access in various places, including the London Stock Exchange website and the Company Investor Relations website. Now, ultimately, the profit loss account, the top line is literally revenues or sales. And we're talking about profits here, but really revenues and profits for vanity, cash flow for sanity.

We'll come back to that. But again, the panel is the first part. We'll look at the others and tie them all together. Now again, the next point to remember is this is a snapshot. It covers a three, 6 or 12 month period only, and it's historic. Stock markets will always be looking at a company's track record over time, and they'll be looking just as important as to what they think it's capable of doing in the future.

Because stock markets are forward looking discounting mechanisms, they may well try may well try and extrapolate from what they've seen right now. But again, these are not correct answers. They may catch a company of a particularly bad time, covet a recession. They may catch it at a really, really good time, a boom, an economic upturn. So it's up to us to decide.

Then as investors, where not just how the numbers look now, are they sustainable, what are the circumstances behind it? And this is as much the art behind these numbers as the science you also need to think about, again, if we're covering a particular period of time, why is a company chosen a particular financial year? Is it going to be January to December?

Is it going with the tax year of April to March or is it like some housebuilders go with, say, April or June? Why is that? Well, because they build the things over winter. So the cash is all tied up in bricks and mortar, and then they sell them in the spring. So that's when the cash comes in. Do you want to publish your accounts and balance sheet when the cash is all tied up in old school bricks, or do you want to publish it when you've sold those houses and you can go to your banks and shelves and say, look what a fantastic job we're doing.

Why do retailers publish their accounts, perhaps for the end run to the end of January? Because at the end of December, they might not have got all of the Christmas monies in the end of January they probably have. So again, it's a little bit of timing. It's not illegal. It's not even a little bit of sleight of hand.

It's just presenting the numbers with the best way that they can to reassure you. A shareholder encourage you to perhaps have a look at the stock when you do your research, and certainly at least reassure again, insurance providers, bankers, lenders, even staff, they won't say so. Again, interpretation is required. Finally, one thing we will come on to. Please beware of this awful trend and I use the words advisedly.

I've been doing this for over 30 years, and I think in some ways now, the way in which company results are presented has never been more confusing, which is why we're doing the six sets of video of videos. Beware of adjusted versus statutory. Statutory means abiding by required accounting standards. Adjusted can mean company marks on homework. So then it's up to you to decide which figure you feel is worth putting the most faith in.

I will say, generally on a day of a set of figures, the market will probably go with the adjustments because that's what the company will talk about over time. It's the statutory that really, really, really matters. In my opinion. And that will help you judge not just quantity of earnings, but quality.

So this is just to give you an example. It's a Footsie 100 company hammer. This is not investment advice or a recommendation but it is an acknowledgment of a company. It's got a tremendous long term growth record and also is pretty straight and transparent in how it presents its accounts. Even here, however, you can see there's difference between adjusted and statutory numbers.

That -5657 million charge is a reflection of a revision of valuation of the assets on its balance sheet. Intangible assets like brands or businesses that it's acquired previously. But overall pretty straightforward. And you can also get a very quick view now of the different levels or different parts of how a profit loss account and how they fit together.

Sales at the top, the top line then knock off costs to get to pro operating profit. The pumping, beating heart of the company, the best measure of its day to day operations, ad financing income, take on financing costs, get to pretax profit, knock off tax, get a net profit. And as we'll come to shortly, that's one of the most important line of all for us is shareholders equity investors operating profit.

Great measure of efficacy of business and strategy. Net

Divide net profit by number of shares, earnings per share. Simple steps down. The more often you look at it, the more easy, the more comfortable you'll see with it. But that's very quickly the mathematics of it. How I presented it in a nice clean table. There, and you can quickly build up your own spreadsheet if you want and build it back, going as far as you wish.

If you're feeling particularly diligent to get a really clear picture of a company's history and its potential and the upsides and downsides, this is how these numbers are presented really. Detective work quite required. And also the company does put the adjusted numbers first, which is pretty standard operating procedure. Not a fan of it myself, but that's what we're going to have to get used to here.

And how much numbers. Again, pretty transparent and pretty plain.

So first things first, people can get confused between sales and profit I understand that. So this is what we're here to help you with. And again cut through the complexity sales revenue turnover top line all mean the same thing. And that's when a customer buys a products or service from a company and they hand over the money.

And that is a sale. That's it. Then it's up to the company to manage its cost base properly so it make a profit from that sale. Okay. Now companies, if they're really being cheeky, can play fast and loose with what's known as revenue recognition. Now it's pretty obvious if I buy a packet of sweets from you in a shop, then you can almost you can immediately revenue recognize that revenue because the cash has come in and I've got the sweets.

What if I sell you a photocopier? Fine. You might pay me. You'll give me the cash for that pretty quickly? Certainly within 90 days. Anyway, I said, what if I sell you ten years of ink? When do I book the revenue? If I'm being cheeky, I can book the whole lot. Now. A ten year contract right up front.

Flatter my numbers because don't forget, I'm booking the revenues. But I'm not associate booking any of the associated cost with supplying the ink. Flattering my numbers. What you should do is it come to those circumstances? It's cut the revenues up into ten slices, probably for a ten year deal, ten slices of course, then slices of profit. And that's a much more representative picture of the flow of the business.

But it doesn't mean some companies necessarily strictly adhere to those rules. And those we'll discuss in part three. Video number three, it's often in the cash flow, the balance sheet, what any sleight of hand like that starts to show up. But for right now we're looking at the profit and loss account. We've started with sales, the top line turnover revenue, knock off the costs and then you get to profit.

But as we've already discussed looking at the previous slide of much numbers, there are different types of profit. And this is the full list you'll hear about. Gross profit is knocking off cost of goods sold like raw materials, operating profit. Then you knock off sales, marketing, research, development overhead admin pretax profit. Then you knock off add on financial challenges, interest.

Then you knock off tax to get to net profit. And that's when you get to the bottom line. So if sells is the top line, net profit is the bottom line. Now you can look at each of those numbers, divide it into the sales figure and get a profit margin figure expressions a percentage.

And obviously for pretty standard reasons, the higher the profit margin, the better a job you can say that a company is doing. Some businesses are inherently high margin and frankly, some are not, inherently high margin. We'll discuss later. But things like branded goods, if you've got a really strong brand, then you're in business. If you're selling stale.

While the cyclical commodity, fierce competition offerings and state backed companies know very, very thin margin business, even food retailing wildly competitive 3 to 4% operating margin at best. The AG or Unilever, who sell the stuff that's on the shelves 18 to 20% operating margin. So again, you're already getting a feel just looking at the numbers, who's maybe got the power in that discussion between the two, who's maybe got the stronger competitive position or the stronger brands, and how do those things interlink.

And that's really what we're looking for when we're starting to think about whether a company is a good investment or not, quantity and quality of profit. But there the different measures that you'll come across now, some industries then to make it even harder for you, will use metrics all of their own. Oil will adjust profits for current cost of supplies.

The variations in the the value of the oil price. Retailers will look at gross margin. For example, miners, which are quite capital intensive, will look at EBITDA earnings before interest, depreciation, taxes and amortization. The depreciation, because the really heavy equipment that they use the kit gets tired, gets old, has to be replaced. And there's an accounting measure for that called depreciation, which you take half a percentage value of the kit over time to reflect the fact that it's just going to get old and has to be replaced.

And that can be the same for very other capital intensive industries paper, pulp, steel, automotive for example, for example. Now companies will try and point you towards the metric that they think serves their purposes best. It may give you a better insight into the actual heart and guts of the business, and what really makes it tick. It might be just to make things better so that management, stock options, cash in or everybody gets a bonus, or just to get the share price up.

Or again, convince a bank that actually things are maybe a little bit better than they are. Hence the detective work, the art behind the signs. And hopefully these videos help you cut through the complexity that comes in.

again why does it matter what profit. We talk about what it matters enormously. And this table explains why. Because as an equity investor a shareholder we are bottom of the pecking order of creditors. If, heaven forbid, a company goes bust. Now, hopefully we won't encounter such difficulties because will, with the help of these six videos, will be able to avoid such accidents.

But this is when you hear O company X failed and investors got so many pennies in the pound. If I say if anything, it's normally nothing for investors because they're absolute bottom of the pile. So the fact that we're bottom of the pile, well, who are we behind the liquidator, lenders, the banks, the taxman stuff. So they own the parts further up the PNL.

They own EBITDA, they own operating profit. The taxman owns pretax profit. We own net profit. So yes, companies can perform about EBITDA, but in the end and they'll do it because that might help reassure their banks. But in the end, as shareholders, it's net profit that we're really interested in because that's what we own.

Warren Buffett 94 still going strong, still got a fabulous long term investment performance record. I know it comes and goes all the fashion. Like all investment styles do, but overall it stands the test of time. And just take a good look at these quotes from somebody who really, really knows what he's doing and who, by the way, does not believe the investment is on what he thinks is going to happen.

The only reason historic sets of reporting accounts earnings can be as pliable as Potti. When a charlatan heads a company reporting them, eventually, truth will surface. But a lot of money can change hands in the meantime. And again, this point that we made right at the start in video one, these numbers are there as an aid to thinking, not a substitute for them.

Okay, this is just me. This is not to pick on Ocado, but it is a share price that has gone from very high to very low. And this may be a contributory factor. Why the company may say it makes a profit using its adjusted EBITDA metric but using statutory numbers. No it doesn't. And in fact it is only managed it once I think in its entire history, maybe twice.

Which again, is why ultimately investors have become increasingly impatient. So again, how those numbers are presented is funny enough. Investors will tend to be very forgiving when the share price is going up and maybe be more accepting the adjusted number. They'll be a lot less forgiving if things don't start to go quite as well. The share price goes down.

That's when they might home in on the statutory stuff and say, you know what? This doesn't look quite so good. But again, if Accardo does start to churn out statutory net profits, that could be different again. And that's again a decision that you would have to make as a shareholder. But that shows you, again, just some of the adjustments that are made between adjusted EBITDA and statutory numbers.

And it's up to you to decide which you think is really, really more helpful when it comes to understanding just how well and measuring just how well a company's strategy is working, not just in one year, but over a period of time. So again, just to conclude this second video, company accounts come in three parts profit and loss account, cash flow balance sheet.

And they're all interlinked when it comes to the PNL. Lots of different ways of measuring profit. My preferred to operating profit gets is the pumping heart of the company operating profit divided by sales, operating margin, good measure of brand strength, pricing power, technological edge. Market share. Competitive position, net profit. Well, that's ultimately what we own. The shareholders, none of the other stuff because that's where we come in the pecking list of creditors.

We must think about why a company presents its results in a certain way, which metrics are used. We must think about the time frame over which it presents them, and we must remember that again, these are just a snapshot. There's no right answer here. And if anything, the really diligent investor won't just look at one year back and one year forward.

They look at maybe 5 or 10 years of historic performance, or at least a cycle, so we can see if certain circumstances serve it really well. Certain circumstances will treat it really badly. And how does the average look over time? Because in the end, reversion to mean is basically how capitalism works, right? If something is doing really, really well today, we will try and shock in and get a piece of the action.

If some is doing really, really badly with other will take over, I'll get kicked aside. So again, that's not just one year, you know, it's a start, but it's not enough. Let's try and get that full around a picture. And you're the way get the full around the picture is looking at the cash flow and the balance sheet.

And we'll come back to that in the next video.