Interpreting company reports and accounts
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3. What to look for in the P&L
The function of the P&L is to provide information on the company's performance, particularly its profitability.
You can use the P&L to compare last year's performance with the previous one, to calculate profit margins, check on the volatility of profits and check dividend cover.
Click here for an example of a profit and loss account.
The key thing is to approach the P&L with an understanding of what secrets it can yield up, and to have the right questions in your head when you look at the numbers.
- Is the business thriving?
Pretty obvious really, and the answer doesn't have to be complicated either.
Look at the sales figures for the last few years - are they rising?
Look at the profit figures for each year, and work out the profit margin - is it getting better or worse? - Are all the divisions doing well, or are there problem areas?
Turn to the footnote providing a segmental analysis of sales, profit and assets. Using the figures there you can work out the margins and the return on assets for the company's different activities.
Which ones are doing well, and which ones are not?
What does management say about the emphasis for the coming year? - How volatile are pre-tax profits likely to be?
High fixed overheads and high borrowings can produce volatility in profits, because a drop in sales or an increase in the cost of borrowing will eat directly into the bottom line. And if profits drop, dividends - your income - can be jeopardised. Check the gearing ratio. - How safe is the dividend?
If a company is paying out most of its earnings in dividends, any drop in earnings is likely to provoke a dividend cut. Calculate the dividend cover. - Was growth organic or by acquisition?
A business that grows organically is making more of its existing business, which means that EPS should rise. A business that grows by acquisition may increase sales and profits but if it has issued new shares to pay for targets its EPS may actually drop. It is fairly easy nowadays to spot acquisition-based growth because companies have to separate the profits of businesses recently bought, sold or discontinued in the P&L. - Is the company making a good return on capital employed (ROCE)?
Profits may be improving, but if the company is only doing that by increasing the capital employed in the business, it may not be a worthy home for your money. Do the ROCE calculation - How does the company compare to its competitors?
If a company's profit margin and return on capital is half that of its competitors it may be a bad sign (poor management) or it may be a good sign (plenty of room for improvement). Analyse the P&L from a comparative point of view by looking at other companies in the same sector.
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