Basic financial statements (Profit and Loss Account)

By RAYMOND ROY TIRUCHELVAM

FOR a non-finance person, evaluating a company's financial can be daunting, let alone understanding it to form an opinion. The most basic form of financial statements comprises the Profit & Loss Account or sometimes referred to as Income Statement and the Balance Sheet.

Another two statements that make a complete financial information for reporting purposes comprise the Statement of Retained Earnings and Statement of Cash Flow.

The objective of a financial statement is to provide information about the financial position, performance and changes in the position of an enterprise.

The Balance Sheet represents the financial position or net worth of a business entity on a specified date. The presentation is based on a fundamental accounting equation of Assets = Liabilities + Shareholders Fund. The main categories of assets are usually listed first, usually in order of liquidity. Next follows liabilities, short and long term, which represent payables and borrowings held by the entity.

The difference between the assets and liabilities (Assets Liabilities = Shareholders Funds), is known as Shareholders Funds, or sometimes referred to as owner's equity, that entails the company's capital plus retained earnings. Borrowings (liability) or owner's money (owner's equity) are the two means used for financing an asset.

Mathematically, over a period of time, if the assets grow bigger than the liabilities, it would mean that the entity has made a profit (which represents the essence of the Profit & Loss Account); this is reflected via an increased asset base (taking shape in many forms from cash, inventories, accounts receivable, fixed assets or investments).

Reverting to the Balance Sheet equation, the Shareholders Fund will reflect the increment. Since the entity's capital remains constant (unless the new assets are caused by new share issues), the increment is credited to a special account called Retained Earnings, as the name denotes.

Next, the Profit & Loss Account represents summarised transactions of an entity's performance over a given period, showing its profitability (or losses). Acting as the management's scorecard, it identifies the revenues and expenses undertaken which results in either a profit or a loss, based on the fundamental accounting concept of: Revenue Expenses = Profit (or Loss if expenses exceed revenue).

This in return will drive the direction of the Shareholders Fund (in particular Retained Earnings sub-category), for good (profit) or for worse (loss).

The particulars of a regular company's Profit & Loss Account would look as in Table 1.

There is also a category of item to be on the lookout called Unusual Item, which represents non-recurring non-revenue based transaction undertaken by the entity that results in a profit or loss. Examples of MAS selling aircraft, discontinuing a business line, incurring losses from natural disaster, writing down of investment value, are a few, which should be evaluated separately from the results from operations.

Due to its importance, EPS or Earnings Per Share is also required to be disclosed at the end of the Profit & Loss account. It presents the earnings divided by the total ordinary shares outstanding.

This single measure differentiates the efficiency in the earnings between companies, and represents the most important criteria in determining the price of the entity's shares and is used as a component to derive the all important PE or Price to Earnings ratio.

A large Retained Earnings balance as compared to the total Shareholders Fund, will denote a profitable company (accumulation of profits over the years), and a negative Retained Earnings (or Retained Loss) reflects the opposite. In extreme cases, the Retained Loss (debit balance) can overtake the Share Capital (credit balance), thus resulting in a negative Shareholders Fund. One surely would not want to invest in such a company.

Some listed companies, when the Retained Earnings gets so large (coupled with other factors such as inability to pay out dividend), reward the shareholders via Bonus Issue exercise, whereby part of the retained earnings are converted into new shares, accruing to existing shareholders.

This not only represents a short cut of the dividend payout, but also a tax free option via capital returns.

Raymond Roy Tiruchelvam, who has problems reconciling his gross habits with his net income is a financial planner with SABIC Group of Companies.