Business - Profit and Income Statements

Most businesses exist for profit. Businesses want to increase their profit each year to become more successful. To do this the business needs to measure profit on a regular basis. They compare their profits from the current period (usually a year) to the profits from the previous period.  

Businesses can improve profit by:  

• Increasing their prices (if the demand for the product is high)  
• Reducing their prices to increase demand (increase the number of products sold)  
• Reduce the costs of production  
• Advertise to increase demand 
• Improve quality  
• Limited time promotions  

There are three ways of reporting profit: 

• Gross profit 
• Operating profit 
• Profit of the year (also called Profit After Tax) 

Shows the money being made from actually making and selling products. Businesses want gross profit to be as high as possible.  

Gross Profit = Sales Revenue – Cost of Sales 

Sales Revenue = the money made from selling the products or services  

Revenue = price x quantity 

Cost of sales = how much it costs to directly make the product e.g. the cost of raw materials  

Cost of sales = cost x quantity 

Shows the money made from ‘normal’ business operations. How much money the business makes by opening every day.  

Operating Profit = Sales Revenue – Cost of Sales – Operating Expenses (Operating Profit = gross profit – operating expenses) 

Operating Expenses = an expense a business incurs through its normal business operations e.g. rent, staff wages or marketing costs  

(operating expenses = all costs added together)  

This is the business's Net Profit (what is left over after all the costs of the business have been taken away from its revenue). It tells you if the business is profitable or not. It’s the measure of profit that dividend (paid to shareholders) payments are based on. 

Profit for the Year = Operating Profit + Other Profit – Net Finance Costs – Tax 

Other Profit = money made from selling assets and one-off events  

Net finance costs = other costs incurred by the business not related to the operation e.g. interest payments 

Tax = the tax paid by the business 

Income statements (also called Profit & Loss statements) show different measures of profit.  

It's a way of reporting profit or loss over a certain period of time (usually a year). Any time period less than a year can be misleading.  

A business can perform in one of 3 ways: 

• Profit = make a financial gain (make money) 
• Loss = make a financial loss (lose money) 
• Break Even = point at which expenses and revenue are equal (make no money) 

 Each measure shows different things about the company's finances. 

• Gross profit is revenue minus cost of sales 
• Operating profit is revenue minus operating expenses (or gross profit minus operating expenses) 
• Profit before tax takes into account any profit or loss from one-off events, and other expenses such as finance costs.  
• Profit after tax (also called profit for the year) is what’s left after corporation tax has been paid  
• Retained profit is what’s left from profit after tax, once share dividends have been paid to shareholders 

Businesses can use their profits to pay dividends to shareholders if they are a PLC or they could pay an amount to the owner of a Private Limited Company. They can keep the profit in the business as retained profit. 

PLC’s have to publish their accounts in their annual reports so that they’re available to anyone who wants to see them including shareholders and potential investors. Annual reports are legal requirements of registering with Companies House. Income statements show shareholders and potential investors of your business is worth investing in as it can be used to assess business performance.  

Shareholders usually want companies to pay high dividends so they get a good return on their investments.  

Businesses usually try to find a balance between dividends and retained profit – they pay a proportion of their profit to their shareholders and reinvest the rest back into the business to fund growth.  

• Gross profit shows the money being made from actually making and selling products. If gross profit is low, managers need to look at ways of reducing the cost of making the product, or increasing the selling price. 
• Operating profit shows the money made from ‘normal’ business operations. If operating profit is significantly lower than gross profit, it could show that the company’s operating expenses are a weak area. Managers should take steps to reduce these expenses e.g. by reducing marketing costs. However, the operating profit could reflect a big investment in people, premises, etc. Banks and investors will look at this figure to assess the risk of lending to or investing in the business. 
• Comparing profit before tax to operating profit shows if income or expenses are coming from other activities. (e.g. selling or buying a building), rather than ‘normal’ activities (e.g. making and selling goods), which may not continue in the future 
• Profit after tax tells you if the company is profitable or not – shareholders and potential investors will look at this figure to assess investments 
• Retained profit shows how much internal finance the company has available to invest, which shows how strong its growth potential is.