How to analyse a Profit and Loss statement in 6 simple steps
6 Steps to analyse a Profit and Loss Statement
1. Evolution of Sales
Size, growth, seasonality, cycle effects (global and by product).
Sales growth will probably mean growing financial needs (growing credits, but it is also an indicator of good business potential).
Seasonality; peak sales in some months
Cyclical; very sensitive to the economic cycle
Vertical and horizontal analysis (study of sales and expenses in general)
Vertical analysis consists of dividing all the items by sales to get % with respect to sales.
Horizontal analysis can be done in two was; 1. Every item divided by the base year or, 2. Example; (2019-2018)/2018
Business potential vs. growing financial needs
2. Evolution of the Gross Margin
Gross margin: Margin/Sales (in %)
Look at the size and its evolution in recent years
Compare with the Gross Margin in % of other companies in the same industry
Often problems start with deterioration of the margin % (take this into account)
In a very competitive market, if you do nothing, your competitive advantage will fade away and the margin will decline little by little.
If margin in % decreases, it can be due to two reasons:
Decline of prices
An increase in COGS in %, which can be due to; 1. More expensive components 2. More expensive labour
3. Evolution of the Operating Expenses (OPEX)
Look its evolution over the years
Compare it with the margin in %
If a company doesn’t make money, it’s usually (NOT ALWAYS), due to or because, of little margin or big OPEX %.
EBITDA/Sales: company’s profitability from the ordinary operations.
4. Variation of significant numbers
Probably, at this point, the diagnosis of the Profit and Loss is already carried out just by looking at sales margin % and OPEX % but, sometimes there are may be other big numbers in the Profit and Loss with impact on the net income.
Look at the size of depreciation; An increase in depreciation, is a negative sign, because even if it is not an immediate expense, you spread the cost along a certain amount of years that depends on the type of asset you have.
Look at the size of financial expenses > % sales. EBIT/Financial expenses > 2.5 (Safer financial situation because this will mean that FINEX are lower. Example; 30/10 = 3 > 2.5)
5. Profitability; Does the company make money?
Look at the size of the profit (in dollar/euro terms) and its evolution. Compare it with the size of debt (D, Debt: total debt). You may also calculate the CFO, or cash produced by the Profit and Loss (Net income + Depreciation (everything)). Compare the CFO with the Size of debt and with the investments in Net Assets (Total Assets – Total liabilities) expected for the future. This will give you an idea of whether the company will produce enough money to cover the repayment of debt (Long Term) and the new Investments (Assets), and if there will be enough money left for shareholders.
ROS (Net income / Sales) – Return on Sales; look its evolution and compare it with the industry average.
ROE (Net income / previous year’s equity) – Return on Equity; - It gives an indication of how profitable the company is for shareholders. - Should be similar to either the average ROE of the industry, the average ROE of companies listed on the Stock Exchange Market, or both. - Should be bigger than the cost of debt (FINEX/total debt) or return that lenders (banks) obtain when lending money to the company. (ROE > Cost of debt) - Shareholders take more risks than lenders and, in theory, they should obtain higher returns, this is not applied when interest rates are high as it’s the usual case in developing economies. - The difference between ROE (or return for shareholders) and the cost of debt rate is called = risk premium and it’s to get an idea of the profitability shareholders get of the company (for each € they put, how much they receive).
ROA (EBIT / Total assets). This should be compared with the return of alternative investments such as; Stock Market, Bonds, Other Industries, etc. Other synonyms are; - ROCE (Return on Capital employed) - ROI (Return on Investment) It’s basically the profitability produced by the assets if they were financed exclusively with capital and no debt.
6. Risk identification
Risk of Profit and Loss or what could go wrong (decrease in sales, decline in margins, etc.) The risk of a component has 2 components
Operational risk; how sensitive is your EBIT to changes in sales, margins and OPEX. We have to conduct a sensitivity analysis to see how these changes affect the EBIT.
Financial Risk; how big your financial expenses are, compared to EBIT. In other words: “how close you are to losses due to financial expenses”.
Example; a sales decline of X % may drive you into losses due to financial expenses. Less financial risk = less debt.
*All content is gathered from Tecnocampus' slides implemented by my own notes and the book; "Finance for Managers - Eduardo Martinez Abascal"
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