The profit and loss account, or P&L, records a company’s income and outgoings over a period of time, typically a year.
Here, the key number you need to extract is operating profit. Put simply, this is what’s left over after the routine costs of doing business (things like salaries, property costs and raw materials).
Operating profit is a good yardstick precisely because it doesn’t include one-off costs like redundancy payments or depreciation.
Once you have the number for operating profit, look at operating margin. The calculation goes thus:
( operating profit / revenue ) x 100
As a general rule, an operating profit ratio of less than 15 per cent is problematic. Always look at margins over the past five years. And remember: Even a tiny swing in margins can result in the loss of millions of pounds in profitability at a large company.
Most companies break out revenue and operating profit for divisions. If they do, use the same calculation to find out which bits of the business are under-performing.
This is a good trick for local reporters with a big factory or depot on their doorstep. If it’s associated with a division where margins are weak, redundancies or a sell-off could be on the way.
Revenue & profit: The P&L measures how efficiently a company converts revenues into profit. Look, for example, at this year’s percentage increase in revenues. Compare it with the percentage increase in operating profit.
Ideally, the latter percentage will be bigger than the former. (This is the origin of the phrase about ‘revenues falling to the bottom line”.)
By contrast, a company that’s growing revenues by 20 per cent, per year, and operating profit by five per cent, is incurring big costs. Either management is incompetent or they’re investing for the future.
Revenue growth: Companies that are loss-making at the operating level usually have only one viable excuse: Growth.
They might be emerging from the doldrums, or colonising a new market. Either way, the rate of revenue growth is vital.
Go back two or three years. Is growth slowing down? If so, why? Because of poor management? Is the economy tanking? Or is the market simply maturing?
The transition from being a growth company to becoming a cash cow can be tricky. Happily for business journalists, it’s often associated with a change of management.
Price-earnings ratio: You won’t find P/E ratios mentioned in annual reports. Yet they are a handy tool for comparing a quoted company with its peer group.
Take the company’s share price and divide it by the earnings-per share figure, published in the accounts. (Use the diluted EPS, if possible.) The result is a P/E ratio.
Alternatively, save yourself a bit of time by heading to Yahoo Finance or FT.com, where you’ll find these ratios already calculated for most FTSE companies.
P/E ratios allow investors to compare the cost of buying shares with the likely size of that company’s profits (and therefore, their probable return on investment).
It’s a classic measurement of risk versus reward. The bigger the P/E number, the more highly the City regards the company’s profit potential in general.
Next week: The balance sheet