How to read a P&L
While investors should have reservations about the 'truth and fairness' of profit calculations, that does not mean we should ignore the profit and loss account.
For one thing, it is often not the P&L account that misleads, but the construction which analysts and other outside observers put on some of the numbers in it. For another, profits are not the only measurement contained in the P&L account.
Ratios worth looking at in the P&L account include those that link profits and sales, namely profit margins.
Profit is, of course struck at various levels in the P&L account: gross (after deducting only the cost of sales from the turnover figure); at the operating profit level (after additional deductions of depreciation, amortisation, salaries and administrative expenses); and pre-tax (after the additional deduction of interest).
There is a margin calculation that corresponds to each level.
Operating and gross margins
Gross margins are the most basic measure of profitability, but don't give the full picture.
Operating margins - operating profits as a percentage of sales - give us profitability after most of the normal deductions have been made apart from interest and tax. Operating margins tell us what profitability is, without any distortions that might be introduced as a result of the company's capital structure (how much debt a company has, and how much equity) or as a result of how efficient a company might be at minimising its tax liabilities.
They are, therefore, the most widely used measure when it comes to working out comparisons of profitability between companies, particularly between companies in the same industry. If you think that manipulating the capital structure is an integral part of management's job - and I'm not sure I do - then pre-tax margins will add that additional dimension to the comparison.
An interesting measure
Interest cover is also a measure worth looking at in the P&L account. This expresses pre-interest profits as a multiple of net interest paid. It is a measure of the leverage inherent in the profit and loss account as a result of the company's debt load. Interest cover of three times is a minimum 'safe' level at times when the course of interest rates is uncertain.
Looked at another way, interest cover of three times means that pre-tax profits are double the interest bill. If interest rates are falling and company debt is at variable rates, a low interest cover will result in a disproportionate boost to profits, and vice versa if rates are rising.
Dividend cover, the amount by which the total dividend payment for the year is covered by after tax profits, is relevant only in the case of higher yielding shares. Here it measures, in effect, the potential risk of the dividend being reduced if profits fall.
Earnings are usually struck after deduction of 'minority interests'. These crop up when a company has subsidiaries that are more than 50% owned but less than 100% owned.
The minority interest represents the share in after tax profit of the subsidiary that is attributable to the other shareholder or shareholders in it.
Minorities are, however, only a notional book deduction, rather like depreciation. No transfer of cash takes place. Further up the P&L account, the same is true of the 'share of profits of related companies'.
Related companies are other companies that are more than 20% owned, but less than 50% owned, where the share-owning company is deemed to have some degree of management control. In this case, a pro-rata share of profits can be consolidated but again this is a notional transaction, because all the share-owner will receive in cash terms is a dividend, if one is paid.
P&L accounts are arguably more useful than they once were, because companies have to disclose more, for instance about the contribution from acquisitions. But they still suffer from a fundamental drawback, which is that profit is a hypothetical construct.
There are several notional elements to profit and the big swing factor which is not taken into account is movements in working capital.
As anyone who has run a business knows, it is one thing to sell an item or a service at a price that produces a profit, but unless customers pay up on time that profit is not secure and is, at worst, an illusion.
This simple fact needs to be borne in mind when working out any ratio that involves a profit numbers. It's also the reason why some analysts and investors, me included, prefer to use cash-flow as the basis for valuing a company.
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