Income statement: various levels of profit and informational aims
The income statement shows the entity's performance in terms of profits, i.e. how the entity has transformed inputs in more valuable (when the profits are positive) outputs.
The first profit you might come across, when reading the income statement of your chosen entity (you can refer again to the annual reports indicated in chapter 1 - Introduction) is the gross profit. This profit shows the value that the entity has added to the value of the inputs that the entity has used to produce what has been sold. The equation for gross profit is:
"Turnover - cost of sales = gross profit"
o 'turnover' is the value recognized by the entity's clients and customers for the production that has been sold. Turnover is also called 'revenues', 'sale revenues', 'sales'
o 'cost of sales' or 'cost of goods sold' is the cost of production of what has been sold. This means that the costs of what has been produced but not sold are not included in here nor, indeed, anywhere else in the income statement.
Hence, gross profit represents the ability of the entity to make its clients and consumers recognize a value for its products or services, which is higher than the cost of producing them. You can expect a comparatively15 high gross profit, from entities whose brand is renown as one of high quality, and a comparatively low gross profit, from entities whose brand is unknown or known as one of low price products or services.
Gross profit is not always shown on the 'face of the accounts', i.e. in the page of the income statement, but is often shown in the notes to the accounts that refer to the next line down of the income statement, i.e. the operating profit. Certain entities choose not to show the gross profit; this is allowed by the IFRS/ IAS and is particularly obvious in businesses where gross and operating profits are difficult to separate. The reasons for this occurrence will be explained below, in the section on 'operating profit'.
Operating profit and profit before interest and tax
The operating profit results from deducting from the gross profit further expenses and adding any operating income that was not included in the turnover. These are called, respectively, 'other operating expenses' and 'other operating income'. The former represents: (i) administrative expenses, i.e. the costs of running the personnel office, the accounting department, the costs of legal advice, etc.; and (ii) distribution costs, i.e. those related to marketing, transport of finished goods, promotion, etc. Other operating income includes any income that comes from the operations of the entity, i.e. from producing, buying, selling, licensing third parties to use patents, brands, logos, etc. but is not originated by the entity's core business.
Other operating expenses and income can originate also from 'exceptional items', i.e. as the result of events that are exceptional by nature or size. For example profit or loss deriving from disposal of non-current assets is an exceptional item by nature, given that the entity is not normally disposing of its non-current assets, it is instead using them for production purposes. Also, profit deriving from an order of exceptional size, albeit of typical nature, is an exceptional item. The income and expenses deriving from the exceptional items can also be shown separately, below the operating profit; this choice is allowed by the IAS/IFRS.
As mentioned in the section above on gross profit, in certain entities, typically in service industries, all operating expenses are incurred on as part of running the core business; often there is no distinction between cost of sales and other operating expenses. For example, in airlines, it is difficult to draw a line that separates the administrative and distribution costs related to issuing a ticket (or processing an electronic booking) and the cost of sale of the same ticket. What about the check-in operations? Are they simply enabling the production of the main service of transporting passengers or are they part of the actual production of the service? Browse the British Airways latest annual report16 to find out how this entity has solved the problem of reporting its performance. As you will see, a list of the major categories of costs is presented with no distinction of what is 'cost of sales' and what is 'other operating expenses', but with a useful level of detail.
Profit before interest and tax represents the profit made by the entity from anything but financial income and costs. In other terms, below this line you will find other income related to financial investments, i.e. mainly interest, as well as other costs related to borrowing, i.e. once again mainly interest - unless the entity is operating in the banking sector, where of course interest payable and earned are part of the core business.
Only in case the exceptional items have been shown separately, you will find that profit before interest and tax and operating profit show two different values. If the two values are the same, chances are that you will not see both reported (what would the point be?). This might confuse you, when you compare two or more entities, where one reports an operating profit and the others report a profit before interest tax, but they all might refer to the same concept.
However the layout is arranged, the operating profit is a key value for the evaluation of the performance of a reporting entity in that it represents the profit that the entity has been able to create from its operations (including or not including exceptional items and with separate consideration of the discontinued operations, if it is the case). The operations are at the core of the entity's business and, where the operations provide a healthy profit, the entity is achieving one of its main targets, i.e. produce wealth. In this case, whether this wealth actually reaches the owners, making the entity fulfill its main reason of existence, depends no longer on the entity's operations but on how it is financed, given that the only remaining cost to be deducted from the profit before interest and tax, is the cost related to the financing of the entity. This is the reason why, when analyzing the performance of the entity, it will be important to devise, in the context of the specific analysis, whether it is appropriate to consider or to exclude exceptional items or the discontinued operations, depending on whether the analysis aims at evaluating the performance of the specific period under consideration or is more focused on the underlying performance of the entity. More on this matter will be considered in the next chapters of this guide.
Profit after tax and retained profit
Profit after tax results from deducting tax from the profit before interest and tax. The deducted tax is the amount of taxation calculated from the profit before interest and tax, regardless of any public policy that, as it happens, allows postponing the payment in certain circumstances.
This form of profit is also called 'profit attributable to the shareholders, meaning that the owners are entitled to that value created by the entity; part of this profit will reach the owners directly, when dividends are paid out, the remaining will be reinvested in the entity itself, becoming 'retained profit' that goes to feed the equity. As the shareholders' equity represents the book value of the entity, the owners see their capital increase in value by the 'retained profit', which is a distributable reserve of the shareholders' equity - as illustrated in figure 5.
Figure 5 - the allocation of profit attributable to the shareholders
In broader terms you can look at the income statement as the valuation of the allocation of the wealth, originated by the operating and financial income, to various different parties, which are the entity itself, suppliers of materials and services, employees, providers of credit capital and providers of equity capital - as illustrated in figure 6.
Figure 6 - the origins and destination of income