The Study of Stock Market through Fundamental Analysis

Lesson -> Let's Understand The Profit and Loss Statement (Part 02)

5.1 - Details about Expenses

We had learned about revenues that a company generates in the previous chapter. We will now move on to the P&L Statement. In this chapter, we will examine the Profit and Loss Statement's expense side, along with the notes. You can classify expenses according to their function. This can also be called the cost of the selling process or the expense type. The Profit and Loss statement, or the notes, must include an analysis of all expenses. You can see that almost every line item has a note attached to it, as you can see from the below extract.

The expense line's first line item is the 'Costs of materials consumed'. This is the raw material cost required by the company to produce finished goods. The company's biggest expense is, as you can see from the chart, the cost for raw material consumed/raw materials. This expense is Rs. 2101 Crs in FY14 and Rs. 1760 Crs in FY13. This expense is described in Note 19; let's examine it.

You can see that note 19 provides details about the material used. The company uses lead, alloys of lead, separators, and other items that add up to Rs.2101 crores.

Next are 'Purchases of Stock in Trade' and 'Changes to Inventories finished good, work-in-process & stock in trade'.

Stock in trade purchases refers to all finished goods purchased by the company for the purpose of running its business. This amount is Rs.211 crore. This line item will be clarified by me shortly.

The inventory change refers to manufacturing costs incurred by the company in past. However, the goods manufactured in past years were sold in the current/current financial year. For the FY14, this is Rs.29.2 Crs.

Negative numbers mean that the company manufactured more batteries than it sold in FY14. To give an indication of the ratio in terms of sales and costs, the company subtracts current year costs from the cost of manufacturing additional goods. If they can sell more products, this cost will be added into future sales.. This cost, which is added back by the company later, will be included in the "Purchases Stock in Trade" line item.

Below is an excerpt from Note 20, which details the two above-line items.

These details are simple and easy to comprehend. It may not be necessary at this point to go deeper into the note. It is helpful to have a complete picture. We will dig deeper into this topic if we choose 'Financial Modeling as a separate module.

Next on the expense side, "Employee benefits expenses" is the next line item. This line item is very intuitive because it includes expenses incurred for salaries paid, contributions towards provident funds, and other employee welfare costs. For FY14, this amount is Rs.158 crore. Take a look at note 21 for details on the 'Employee benefits Expense'.

Let's think about this: A company that generates Rs.3482 crores spends only Rs.158 crores, or 4.5%, on its employees. This is the norm for most companies, at least those that are not IT. It might be time to reconsider the entrepreneurial dream that you have nurtured.

Next is "Finance Cost/ Finance Charges/ Borrowing Costs". Finance costs refer to interest and other expenses incurred by an entity while borrowing funds. The interest is paid by the company to its lenders. The lenders could be banks or private lenders. The company's financing cost for FY14 is Rs.0.7 Crores. We will discuss the debt and related issues later when we address the balance sheet chapter.

The next line item after the finance cost is the "Depreciation & Amortization" costs, which are Rs.64.5 Crs. Understanding the concept of tangible assets and intangible assets is necessary to understand amortization and depreciation.

A tangible asset is a physical item that has an economic value for the company. It could be a laptop, a printer or a car.

Although an intangible asset doesn't have a physical form, it still has economic value for the company, such as brand value and copyrights. Franchises, customer lists, franchises, etc.

A tangible or intangible asset must be depreciated throughout its useful life. The asset's useful life is the time that it can be used to provide an economic benefit to the company. A laptop's useful life could be four years, for example. The following example will help us better understand depreciation.

Zerodha, a stockbroking company, generates Rs.100,000. Zerodha spent Rs.65,000 on the purchase of a high-performance computer server. The server's economic life (or useful life) is estimated to last 5 years. If you look at Zerodha's earning capacity, it is apparent that Zerodha earned Rs.100,000. However, Zerodha spent Rs.65,000/day and retained only Rs.35,000/day. This is a distortion of earnings data and doesn't really reflect the company’s true earning potential.

The asset, even if purchased in this year's fiscal year, will continue to offer economic benefits for the rest of its useful life. It makes sense to spread out the cost of the asset's acquisition over its useful lifetime. This is known as depreciation. Instead of showing an upfront lump sum expense for the acquisition of an asset, the company can show a smaller amount spread over the asset's useful life.

The server's 5-year useful life will see Rs.65,000/- spread out. The server's useful life of 5 years is 65,000/ 5. This equals Rs.13,000/- each year. We are spreading the upfront costs by depreciating the asset. Zerodha's earrings would now be Rs.100,000. - Rs.13,000 = R.87,000/- after depreciation.

A similar exercise can be done for non-tangible assets. Amortization is the equivalent of depreciation for non-tangible assets.

This is an important concept: Zerodha reduces the cost of an asset's acquisition over its useful lifetime. In reality, however, the outflow to purchase an asset is Rs.65,000/. It seems that the P&L isn't capturing this outflow. How can an analyst get a sense of the cash movement? We will be able to understand the cash flow statement in the following chapters.

This is Note 23, which shows the depreciation cost.

At Rs.434.6 Crs, the last line item of expense is "other expenses". This is a large amount that falls under the category of "other expenses". It is worth a close inspection.

It is clear from the note that manufacturing, selling and administrative expenses are all included in other expenses. The note contains all details. The Amount of Money spent by Amara Raja Batteries Limited (ARBL) on advertisements and promotional activities was Rs.27.5 Crs.

Add all expenses to P&L, and Amara Raja Batteries has spent Rs.2941.6 crore.

5.2 - The Profit Before Tax

This is the net operating profit before operating expenses are deducted. This does not include interest or taxes.

The profit before tax (PBT), is:

Profit before Tax (PBT = Total Revenues (TR) + Total Operating Expenses (TOE)

= Rs.3482-Rs.2941.6


But, it seems that there is an extraordinary item/extraordinary item worth Rs.3.8 Crs which should be deducted. Extraordinary items/exceptional items are expenses that occur at odd times for the company and which the company doesn't see as a recurring expense. They treat it separately in the P&L statement.

Profit before taxes and other extraordinary items will therefore be:

= 540.5 - 3.99

= Rs.536.6 Crs

Below is an extract from P&L that shows the PBT (Profit before Tax) of ARBL.

5.3 - Net Profit after tax

After-tax is the net operating profit. This is its operating profit after subtracting its tax liability. Now we will be looking at the last section of the P&L statement: the profit after taxes. This is also known as the bottom line in the P&L statement.

As you can see in the above snapshot, we must subtract all tax expenses from the Profit after Tax (PAT) to get the profit. The current tax is the applicable corporate tax for the year. It is Rs.158 crore. The company also has to pay other taxes. The total amount of all taxes is Rs.169.21 Crore. After subtracting the tax amount of Rs.536.6, we get the profit after tax (PAT), at Rs.367.4 Cros.

Thus Net PAT = PBT - Applicable taxes.

The P&L statement's last line discusses basic and diluted earnings per share. The EPS statistic is one of the most commonly used in financial analysis. EPS can also be used to evaluate the stewardship of the company's managers and directors. Earnings per share (EPS), a sacred number, is used to indicate how much the company is making per ordinary share. ARBL appears to be earning Rs.21.51 a share. Below is the detailed calculation:

According to the company, 17,08,12,500 shares remain outstanding on the market. Divide the profit after taxes by the number of outstanding shares to get the earnings per share. This is how it works:

Divide Rs.367.4 Cros by 17,08,12,500 to get Rs.21.5 per Share

5.4 - The Conclusion

Let's go through the entire P&L statement now that we have reviewed it all.

The statement you just read should now be more meaningful. You will find an associated note for almost every line item in the P&L statement. To get more clarity, you can always refer to the notes. We have only just learned how to read the P&L statements at this stage. However, it is still necessary to understand the meaning of numbers. This will be done when we look at the financial ratios. The P&L statement also close links with the two other financial statements, i.e. The balance sheet and cash flow statements are also closely connected. These connections will be explored at a later stage.

To Summarize

  1. The expense statement in the P&L statement includes information about all expenses incurred by the company over the financial year.
  2. You can examine each expense in detail by using a note, which you can also explore to find out more.
  3. A way to spread the cost of an asset across its useful life is depreciation or amortization.
  4. When the company borrows money to finance its capital expenditures, it pays interest and other fees.
  5. Profit Before Tax (PBT) = Total Revenue(TR) + Total Expense(TE) + Exceptional Items (if any).
  6. Net PAT = PBT - applicable taxes
  7. EPS is the company's earning potential per share. Earnings refer to profit after tax and preferred dividends.
  8. EPS = PAT / Total outstanding ordinary shares