It’s earnings season. For most Indian companies, the financial year runs from April to March, and this makes the earnings they declare in the month of April all the more relevant: These are earnings for the last quarter of the previous financial year, and for the entire year. Some companies, those that are tracked heavily by analysts, often issue earnings guidances for the current year in addition to declaring their results.
It rains numbers during earnings season, and not too many people are comfortable with numbers. With companies, at least the big ones, ensuring that their numbers are prepared and presented in keeping with the principles of Indian GAAP (generally accepted accounting practices), there is a certain degree of uniformity and transparency to financial statements now that wasn’t there before. Still, not too many people understand what the numbers mean and what they signify, about the past and, most critically, about the future. Mint presents, with the help of the latest profit and loss (P&L) statement of Infosys Technologies Ltd, a quick guide to one of the two key statements companies present during earnings season (the other is the balance sheet that will be discussed next week). Three basics before we begin:
First, the definition. P&L stands for profit and loss, which is a slightly misleading term because a company can make a profit or a loss. There is such a thing as accumulated losses, or the losses a company accumulates over a period of time, and it is possible that a company can make a profit one year and still have accumulated losses.
Second, a P&L statement is simply one that relates to money. It shows how much a company spends in the course of doing business, and how much it earns. And it is for a period of time, such as a quarter (which is three months), a half-year (six months), or a year (12 months).
That’s a little different from what a balance sheet shows. A balance sheet is a sort of history sheet of the assets and liabilities a company builds up in the course of doing business. It is a point in time summary (the point in time being the date the company closes its books) of these. It doesn’t show profits or losses, only assets and liabilities, and the two match—which is what the double entry system of bookkeeping is all about. But we’re getting ahead of ourselves and this bit on balance sheets is better discussed when we look at such statements next week.
Third, a P&L statement is structured from top to bottom, much like any statement of account. A salaried individual who maintains monthly accounts, for instance, will likely start from his income, and subtract everything he spends in the course of the month. This is exactly how a P&L works too.
To really understand a company’s performance, compare its results for the quarter in question with those for the same quarter the previous year. People who get the most out of P&L statements use them as a starting point to explore other aspects of a company’s operation: conveniently enough, these are usually presented as schedules to the financial statements by the better companies. And P&L statements work best when seen in the right context. Thus, someone looking at the P&L statement of Infosys would do well to also look at the statements of its peers such as Tata Consultancy Services Ltd and Wipro Technologies, and other software services firms such as HCL Technologies Ltd and Satyam Computer Services Ltd.
1) CONSOLIDATED P&L STATEMENT
Law and good accounting practices dictate that companies declare two sets of results, one only for themselves, and another for themselves and their majority-owned subsidiaries. Anyone seeking to understand a company’s performance should look to the consolidated P&L statement. One of Infosys’ subsidiaries is business process outsourcing firm Infosys BPO Ltd.
Things to look for:Whether the statement is consolidated or standalone; often, people reading P&L statements ignore this basic step.
Tip: Compare the consolidated statement with the standalone statement to understand contribution of subsidiaries.
2) INCOME FROM SOFTWARE SERVICES, PRODUCTS AND BUSINESS PROCESS MANAGEMENT
All P&L statements start with income. Only, in this part of the world, some companies still call it sales or revenue. And some others, old-fashioned ones, call it turnover. This is simply the amount a company earns from its operations. Infosys earns income from software services, products, and business process outsourcing. Many Indian companies also present income by segment, although this is not part of the P&L statement.
Things to look for:Growth, rate of growth.
Tip:Look at income by segment to understand what’s really powering the company’s growth.
3) SOFTWARE DEVELOPMENT AND BUSINESS PROCESS MANAGEMENT EXPENSES
Income is what a company earns from operations. Expenses are what it spends to operate. In Infosys’ case, it would include company spends in delivering services and developing products.
Things to look for:Growth, rate of growth, and a comparison of this rate with the rate of growth of income.
Tip: Schedules to financial statements present a break-up of expenses. Infosys’ wages (for people involved in development and delivery), according to this, rose 42% for the quarter ended 31 March 2007, from the corresponding quarter of 2006. Its income rose by around 44%. The gap may appear small, but it is a company’s ability to maintain this gap, however small, that ensures continued profitability.
This is the difference between a company’s income and the money it spends to earn that income. For a manufacturing company, the second would simply be the cost of goods sold (COGS), and some companies actually use this as a head in their P&L statements.
Things to look for:A first measure of health and growth—is the company growing income at a faster/slower rate than the rate of growth of gross profit? Infosys’ income rose by 44% for the quarter ended 31 March 2007; its gross profit rose by around 46%.
Tip: Most people who read P&L statements underestimate the importance of gross profit. If a company’s rate of growth of income and rate of growth of net profit (which we will come to soon) is higher than the rate of growth of its gross profit, it effectively means that it has been able to sell more of its products and services without spending more on producing and selling them.
5) SELLING AND MARKETING EXPENSES, GENERAL AND ADMINISTRATION EXPENSES
Companies have to market and sell their products. They also incur administrative expenses in running their operations. Commissions paid to agents for sales would come under this. As would money spent on office maintenance.
Things to look for:Growth, rate of growth, and a comparison of this rate with the rate of growth of income.
Tip:Again, look to the schedules; Infosys’ reveal that the company places the salaries and wages of its marketing staff under marketing and selling expenses (it is the largest contributor).
6) OPERATING PROFIT BEFORE INTEREST, DEPRECIATION, MINORITY INTEREST
This is a second-level measure of a company’s profitability after gross profit. It is the difference between a company’s income and all the expenses it incurs. This is also called Ebitda, or earnings before interest, taxes, depreciation and amortization.
Things to look for: Operating profit margin, which is the ratio of operating profit to income expressed as a percentage. Infosys’ is 32% (for the quarter ended 31 March 2007).
Tip: Compare with gross profit margins of peers to understand how the company’s operations (and operational efficiency) compare with those of its peers and rivals.
7) INTEREST AND DEPRECIATION
Companies sometimes fund their operations and capital expenditure (non-recurring big-ticket investments in factories or, in the case of Infosys, campuses) through loans. These involve a yearly payout as interest. And some assets of a company (such as servers and workstations for Infosys or a milling machine for an engineering company) decrease in value every year. This notional expense has to be written off. It is called depreciation.
Things to look for:Rising interest is usually a cause for concern. Infosys, however, has none—it is a debt-free company.
Tip: The schedules attached to a company’s financial statements usually indicate a debt schedule. Is a big loan coming up for repayment/rollover soon?
8) OTHER INCOME, NET
This is the income a company earns from sources that are not related to operations. For some companies, it could be treasury income (or income earned from investing its cash). For others, it could be one-time income arising from the sale of an asset.
Things to look for: Is other income significant enough to distort a company’s financial statement? For Infosys, other income was Rs119 crore for the quarter ended 31 March 2007, which is relatively insignificant when compared with the company’s income from operations for the quarter.
Tip:Ignore other income and redo a company’s financial statement to get a real picture of its financial performance.
9) NET PROFIT BEFORE TAX AND MINORITY INTEREST
This is the third level of a company’s profitability, but its significance is limited purely to accounting and broad-brush inferences.
Things to look for: Broadly, growth rate over the previous year.
Tip:Ignore completely if you want to.
PROVISION FOR TAXATION
How much tax has the company paid or how much does it expect to pay? Again, this is an entry that is relevant for what comes after (net profit) rather than for itself.
Things to look for: Has the provision for taxation suddenly increased?
Tip: All IT companies get tax holidays. Look at analyst or media reports to understand whether Infosys is eligible for these and to what extent.
11) MINORITY INTEREST
This is the income a company derives from its minority holding in other companies and just indicates what it earns as dividend from that holding.
Things to look for:If this is a significant number in the context of the company’s earning, investors should worry and start asking questions. In Infosys’ case it was a mere Rs1 crore for the quarter ended 31 March 2007.
Tip:Ignore completely if number is small.
12) NET PROFIT AFTER TAX AND MINORITY INTEREST
This is the fourth and most important level of a company’s profitability. It is simply called profit after tax (PAT). The ratio of PAT to income expressed as a percentage is called the net profit margin. Infosys’ is around 30%.
Things to look for:Growth. And compare it with the operating profit margin. There should usually be a small difference between the two (2 percentage points for Infosys).
Tip:Add depreciation back to net profit to arrive at a company’s cash profit.
13) EARNINGS PER SHARE
Most P&L statements have a clutch of entries below PAT, but this is the most relevant one for investors. It is simply the net profit, after adjustments, split between all outstanding shares of the company.
Things to look for: Growth, and a comparison with peers.
Tip:If a company has a significant EPS (earnings per share) but does not declare a dividend, it means it expects significant investment activity in the future.
Rachna Monga contributed to this story.
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