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Financial Statements: Profit & Loss

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expenses could be one of the cost drivers. The identification of cost drivers helps in Strategic Cost Management.

Q9) What is Strategic Cost Management (SCM)?

Ans. SCM aims at improving the competitive ability of the firm by reducing costs significantly without affecting the quality. SCM is important as it helps in effective cost management and control. Depending on the cost drivers one can decide on cost management strategy. For example,ferro- alloy manufacturing firms will be benefitted more by reduction in power & raw material costs than by reduction in labor costs.On the other handIT firms may benefit more if manpower costs are reduced.When these basic expenses are subtracted from Income we get a measure known as EBITDA.

Q10) What is EBITDA? How can EBITDA be analysed?

Ans. EBITDA stands for Earnings before Interest Tax Depreciation & Amortisation. EBITDA is critical for business analysis. If EBITDA of a firm is negative, it shows that it isearning an income which is not even sufficient to cover its basic expenses.Such a precarious financial condition cannot continue for long and if this situation persists, eventually the firm will end up in bankruptcy.An apt example will be that of the new Indian telecom companies which had recently acquired licenses. Many of them had negative EBITDA due to which eventually they had to shut shop.

The first requirement for any business unit therefore is to be positive at EBITDA level. This is because apart from basic expenses there are other operating expenses like D & A expenses which need to be recovered subsequently.

Q11) What are D & A expenses?

Ans. D & A stands for depreciation and amortisation. Depreciation accounts for the loss in value of assets such as machinery due to wear & tear. It can also be defined as the loss in value of assets due to obsolescence and passage of time. It needs to be noted that charging depreciation expenses i.e. reducing income by depreciation, every year helps in setting aside funds for future replacement of assets. Amortisation is same as depreciation with the difference that depreciation is applicable for tangible assets while amortisation is for intangible assets. It is important to note that that D &A expenses are different from other operating expenses.

Q12) How is D & A different from other operating expenses?

Ans. Unlike other expenses, D & A is a non cash expense as it is not paid out by the firm.For example wages are paid out by the firm. Similarly raw material charges, advertising expenses are paid by the firm. However the firm never pays D & A expenses to any entity. Thus D & A expenses are non cash expenses.

When D & A is subtracted from EBITDA, we arrive at Earnings beforeInterest (EBIT). EBIT is also called as Operating Income. From EBIT we should subtract financial expenses.

Q12) What are these financial expenses?

Ans. Financial expenses are primarily interest charges. Interest is the servicing costs on the loans taken by the company. The amount of loans taken by the firm is influenced by the financing policy adopted by the firm. It needs to be noted here that some firms reduce the interest they receive on their investments, from the interest they pay on their loans. The figure thus arrived at is called net interest. Apart from the net interest, financial charges also include commission, processing fees etc. When these financial charges are subtracted from EBIT we arrive at Earnings before Tax (EBT). From EBT we deduct the statutory expenses.

Q13) What are these statutory expenses?

Ans. Taxes are the main statutory expenses. These are basically direct corporate taxes to be paid by the firm. In most countries firms have to pay corporate taxes on their earnings (also called as profits). In case of India the tax rate is about 33%. However if a firm plans its tax policy well, it can substantially reduce its tax burden. For example many Indian companies have an effective tax which is far lowerthan 33% due to good tax planning.

When taxes are subtracted from EBT we arrive at Earnings after Tax (EAT).

Q14) Why is EAT significant?

Ans. EAT is final line item in the P & L of a firm. It is also called as earnings. Often it is also called as bottom line as it appears at the bottom of the P & L statement. EAT is significant as it represents profits earned by the firm, which belongs exclusively to the owners i.e. shareholders.The firm can either distribute it as dividends (hence dividends are called as distributed profits). The firm also has the option to plough the profits back into business as internal accruals.Firms normally follow a mixed dividend policy. They distribute part of profits to shareholders as dividends and retain the balance earnings to plough back into the firm for future growth.

In India EAT is commonly known as Profit after Tax (PAT) or Net Profits.

Format of P & L (Profit & Loss Statement)
INCOME
LessExpenses
EBITDA (Earnings Before Interest, Tax, Depreciation & Amortisation)
LessD & A (Depreciation & Amortisation)
EBIT (Earnings Before Interest and Tax)
LessInterest
EBT (Earnings Before Tax)
LessTax
EAT (Earnings After Tax)

Never do business only to increase sales turnover. Earning a reasonable profit is very important. Last but not the least collecting the sales proceeds is paramount. Remember : Sales Volume is Vanity Profit is Reality. Cash is Sanity. Important milestones: First milestone: Be EBITDA positive as fast as possible. Second Milestone: Once EBITDA positive, try and achieve break even quickly. Note: Breakeven is a no profit no loss situation and it accounts for all the expenses Third milestone: Operate above breakeven point so as to earn profits. Once the firm earns profits, concentrate on reducing the payback period. Note: Payback period refers to the period within which the invested capital is to be recovered. Remember we are always given a consolidated P & L statement. The word consolidated means the total of all business of the firm. A consolidated P & L statement shows the total performance of all the business segments. Since it gives an aggregate picture, managers should always ask for the break up segment wise. The business of a firm can be broken up into a number of products or region wise etc. These are called as business segments. This will give them the true picture of the profitability of each business segment. The managers can further analyse and improve the performance of each business segment thus improving the business as a whole.Identify the cost drivers. This is the starting step of Strategic Cost Management.Reducing the cost drivers will yield in maximum cost savings. For example reducing labor will not produce the same results in all firms. This strategy will be more effective in labor intensive business.

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Dr Anil R Menon
Dr Anil R Menon  

Dr. Anil R. Menon is a PhD in Strategy & a post-graduate in Finance. An Engineer by graduation he is a business consultant to leading companies in India and abroad. He also loves mentoring entrepreneurs and his videos can be accessed on YouTube channel menonmantras

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