Chapter 23 - Income Statements (Understanding income statements (Gross…
Chapter 23 - Income Statements
: The financial records of a firm’s transactions
: The professionally qualified people who have responsibility for keeping accurate accounts and fo producing the final accounts.
: Produced at the end of the financial year and give details of the profit or loss made over the year and the worth of the business.
are required by law to
their final accounts and these are much
than those required from non-company businesses, such as sole trader and partnerships.
How a profit is made
Profit = sales revenue - cost of making products
Profit is a 'surplus' that remains after business costs have been subtracted. If these costs exceed the sales revenue, then business has made a loss. Profit formula suggests that this surplus can be increased by:
1) increasing sales revenue by more than costs
2) reducing cost of making products
3) a combination of 1 and 2
Why is profit important? ( to private sector)
reward for enterprise
successful entrepreneurs have many important qualities and characteristics and profit gives them a reward for these
reward for risk-taking
profit rewards entrepreneurs and other investors take risks when they provide capital to a business (allowing payments to be made) e.g. dividends to shareholders
these payments provide incentives: to business owners to try to make their business even more profitable; to investors to put more capital into profitable businesses
source of finance
profits after payments to the owners (retained profits) are a very important source of finance for businesses - this allows for expansion
indicator of success
when some businesses are very profitable, other businesses or new entrepreneurs are given a signal that investment into producing similar goods or services would be profitable. If all businesses in an industry are making losses, this would not be a good signal to set up in that industry
In public sector or state-owned businesses
the government might set profit as one of the targets to be achieved for the businesses. These surpluses could be used as a source of finance to develop the state-owned business or make it more efficient
social enterprises cannot usually survive unless they make a surplus from their operations but profit is not their only objective. The managers of social enterprises will want to balance profit making with other aims such as protecting the environment and benefiting disadvantaged groups in society
Difference between profit and cash
Just because a business records a profit does not mean it has plenty of cash. In fact, it could have no cash at all!
Cash figure could be lower than gross profit because cash payment has been received for only half of them. The customers buying the goods on credit will pay cash in later months.
Understanding income statements
: A document that records the income of a business and all costs incurred to earn that income over a period of time (for example one year). It is also known as a profit and loss account.
if the business is making a profit, managers will want to ask themselves:
is it higher or lower than last year?
if lower, why is profit falling?
is it higher or lower than other similar businesses?
if lower, what can we do to become as profitable as other businesses?
if the business is making a loss, managers will want to ask themselves:
is this a short or long term problem?
are other similar businesses also making losses?
what decisions can we take to turn losses into profits?
: Made when sales revenue is greater than the costs of goods sold.
Gross profit = sales revenue - cost of goods sold
: The income to a business during a period of time from the sale of goods or services.
Cost of goods sold
: The cost of producing or buying in the goods actually sold by the business during a time period.
Gross profit does not make any allowance for overhead costs or expenses
Cost of goods sold is not necessarily the same as the total value of goods bought by the business
: Shows how the gross profit of a business is calculated.
It is not a complete income statement. It is missing:
other costs of running the business apart from the variable labour and material costs, for example fixed costs
taxes on profit paid by the company
payment of a share of the profits to owners/shareholders
In a manufacturing business, rather than a retailing one, the labour costs and production costs directly incurred in making the products sold will also be deducted before arriving at the gross profit total
Gross profit is
not the final profit
for the business because all of the other
expenses have to be deducted
. Costs such as salaries, lighting and rent of the buildings need to be subtracted from gross profit
: he profit made by a business after all costs have been deducted from sales revenue. It is calculated by subtracting overhead costs from gross profits.
is the fall in the value of a fixed asset over time
This is included as an annual expense of the business.
: The net profit reinvested back into a company, after deducting tax and payments to owners, such as dividends.
The income statement for limited companies will also contain:
corporation tax paid on the company's net profits
the dividends paid out to shareholders (in some years, dividends might be zero)
the retained profits left after these two deductions
results from the previous year to allow for easy comparisons
Using income statements in decision making
Managers can use the structures of income statements to help them in making decisions
based on profit calculations
. If a manager has to choose which of two new products to launch, one way of making this decision is to
construct two forecasted income statements