make decisions based on simple statements of profit or loss

Cambridge IGCSE Business Studies (0450) – Making Decisions from a Simple Statement of Profit or Loss

1. Where This Topic Fits in the Syllabus

Syllabus Unit	Key Topics Covered Here
Unit 1 – Business Activity	Profit & loss as a measure of success; how profit influences objectives.
Unit 5 – Financial Information and Decisions	Statement of profit or loss (this note) Profitability & liquidity ratios Link to the statement of financial position Cash‑flow forecasting, working capital & sources of finance Using financial information for decision‑making
Unit 2, 3, 4 & 6	Profit margins influence pricing, production efficiency, staffing, and response to external factors.

Use the profit‑or‑loss statement as a bridge between Unit 5 and the other units – e.g., profit margins affect marketing decisions, while operating costs shape production methods.

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2. Why Do We Prepare a Statement of Profit or Loss?

• Shows the financial performance of a business over a defined period (usually 12 months).
• Shows whether the business made a net profit or incurred a net loss.
• Provides information that managers, owners and external users need to:
  • Assess profitability and efficiency.
  • Set realistic targets and performance‑related pay.
  • Decide whether to expand, cut costs, raise prices or seek additional finance.

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3. The Simple Statement of Profit or Loss (Income Statement)

3.1 Standard Layout (for a small/medium enterprise)

Item	Amount (£)
Revenue (Sales)
Cost of Goods Sold (COGS)
Gross Profit
Operating Expenses (salaries, rent, utilities, depreciation)
Operating Profit
Interest
Profit Before Tax
Tax (percentage of profit before tax)
Net Profit (or Net Loss)

3.2 Key Formulas

• Gross Profit = Revenue – COGS
• Operating Profit = Gross Profit – Operating Expenses
• Profit Before Tax = Operating Profit – Interest
• Tax = Tax Rate × Profit Before Tax
• Net Profit = Profit Before Tax – Tax

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4. Worked Example (Year Ended 31 December 2025)

Given data

• Revenue (Sales) = £120,000
• COGS = £70,000
• Operating Expenses = £30,000
• Interest = £2,000
• Tax rate = 20 %

4.1 Calculations

Gross Profit          = 120,000 – 70,000 = £50,000
Operating Profit      = 50,000 – 30,000 = £20,000
Profit Before Tax     = 20,000 – 2,000 = £18,000
Tax (20 %)            = 0.20 × 18,000 = £3,600
Net Profit            = 18,000 – 3,600 = £14,400

4.2 Completed Statement

Item	Amount (£)
Revenue (Sales)	120,000
Cost of Goods Sold (COGS)	70,000
Gross Profit	50,000
Operating Expenses	30,000
Operating Profit	20,000
Interest	2,000
Profit Before Tax	18,000
Tax (20 %)	3,600
Net Profit	14,400

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5. Linking the Profit‑or‑Loss Statement to the Statement of Financial Position

Net profit (or loss) for the period is transferred to the Statement of Financial Position (balance sheet) as part of Retained Earnings. This links the income statement to the equity section of the balance sheet and shows how profit builds the owner’s capital over time.

Dummy Balance Sheet (as at 31 December 2025)

Assets	£	Liabilities & Equity	£
Cash	30,000	Current Liabilities	20,000
Stock	15,000	Long‑term Debt	10,000
Equipment (net)	35,000	Share Capital	40,000
Total Assets	80,000	Retained Earnings (incl. 2025 Net Profit)	10,000
Total		80,000

In this example the £14,400 net profit for 2025 would be added to the previous year’s retained earnings, increasing the equity side of the balance sheet.

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6. Profitability and Liquidity Ratios

6.1 Ratios Calculated from the Example

Ratio	Formula	Result	Interpretation
Gross Profit Margin	(Gross Profit ÷ Revenue) × 100	41.7 %	Shows how much of each sales pound remains after covering direct production costs. 40 %+ is healthy for many retail/production firms.
Net Profit Margin	(Net Profit ÷ Revenue) × 100	12.0 %	Overall profitability after all expenses. 10 %–15 % is typical for small‑to‑medium enterprises.
Operating Profit Margin	(Operating Profit ÷ Revenue) × 100	16.7 %	Indicates efficiency of core operations before interest and tax.
ROCE (simplified)	Operating Profit ÷ Capital Employed × 100	25 %	A 25 % return suggests the business is generating a good return on the capital it uses.

6.2 Liquidity Ratios (using the dummy balance sheet above)

Ratio	Formula	Result	Interpretation
Current Ratio	Current Assets ÷ Current Liabilities	(30,000 + 15,000) ÷ 20,000 = 2.25	> 1.5 is generally considered safe – the firm can meet short‑term debts comfortably.
Acid‑Test (Quick) Ratio	(Current Assets – Inventory) ÷ Current Liabilities	(30,000) ÷ 20,000 = 1.5	A quick ratio of 1.5 shows good short‑term liquidity even without selling stock.

6.3 Interpretation Guide (What High / Low Values Signal)

• High profit margins → strong pricing power or efficient production; may allow price reductions to increase market share.
• Low profit margins → cost overruns, weak pricing, or intense competition; manager should investigate COGS or operating expenses.
• Current Ratio < 1.0 → potential cash‑flow problems; consider short‑term financing or tighter working‑capital control.
• Acid‑Test < 1.0 → reliance on inventory to meet obligations; risk if inventory cannot be sold quickly.

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7. Limitations of the Simple Statement of Profit or Loss

1. Accrual basis – figures are recorded when earned or incurred, not when cash actually moves.
2. It does not show the business’s cash flow. A profitable firm can still run out of cash.
3. Non‑financial factors (customer satisfaction, employee morale, environmental impact) are omitted.
4. Only a single period is shown; trends require comparison of several statements.
5. Depreciation and amortisation are non‑cash charges that can mask the real cash profitability.

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8. Cash‑Flow Forecasting, Working Capital & Sources of Finance (Sidebar)

8.1 From Profit to Cash

1. Start with Net Profit.
2. Add back non‑cash items (depreciation, provisions).
3. Adjust for changes in working‑capital items:
   • Increase in inventory → cash outflow.
   • Increase in trade receivables → cash outflow.
   • Increase in trade payables → cash inflow.
4. The result is Operating Cash Flow, the amount of cash generated (or used) by day‑to‑day activities.

8.2 Working Capital Concept

Working Capital = Current Assets – Current Liabilities. Positive working capital means the business can fund its short‑term operating needs without external finance.

8.3 Common Sources of Finance (linked to profit‑or‑loss outcomes)

Type	Internal / External	Typical Use
Retained earnings	Internal	Re‑investing profit in the business.
Owner’s capital / share issue	Internal (owner) / External (shareholders)	Long‑term expansion, buying equipment.
Bank loan / overdraft	External (debt)	Working‑capital shortfalls or capital purchases.
Trade credit	External (short‑term)	Delay cash outflow for inventory.
Leasing	External (debt‑like)	Acquire equipment without large upfront cash.

8.4 Simple Cash‑Flow Forecast (3‑month example)

Month	Cash Inflows (£)	Cash Outflows (£)	Net Cash Flow (£)	Closing Cash Balance (£)
April	30,000	25,000	5,000	35,000
May	28,000	27,000	1,000	36,000
June	32,000	30,000	2,000	38,000

Managers compare the forecast with the profit‑or‑loss results to ensure that a healthy profit also translates into sufficient cash to meet short‑term obligations and any planned investment.

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9. Using the Statement to Make Decisions – A Decision‑Making Checklist

1. Profitability Check: Is there a net profit? If not, identify which cost category (COGS, operating expenses, interest) is eroding profit.
2. Margin Comparison: Benchmark gross and net profit margins against industry averages.
   • Low gross margin → negotiate cheaper suppliers or improve production efficiency.
   • Low net margin → review overheads, consider price adjustments (if demand is price‑elastic).
3. Cost‑Control Analysis: Compute the Operating Expense Ratio (Operating Expenses ÷ Revenue). A high ratio suggests a need to cut or re‑allocate overheads.
4. Investment Feasibility: Use net profit together with the cash‑flow forecast to decide whether the business can fund:
   • New machinery (capital expenditure)
   • Marketing campaigns
   • Opening a new outlet or entering a new market
5. Sensitivity Analysis: Model a ±5 % change in sales price or volume.

   New Revenue = Current Revenue × 1.05  (or ×0.95)
   Re‑calculate Gross Profit, Operating Profit, Net Profit.
   

   Assess how the change affects margins and cash flow.
6. External Influences: Consider economic trends, legal changes, seasonal demand or technological shifts that could impact revenue or costs.

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10. Practice Exercise

XYZ Ltd. – Year ended 31 March 2025

• Revenue: £85,000
• COGS: £45,000
• Operating Expenses: £25,000
• Interest: £1,500
• Tax rate: 25 %

10.1 Tasks

1. Complete the statement of profit or loss.
2. Calculate:
   • Gross Profit Margin
   • Net Profit Margin
3. Briefly comment on one possible managerial decision that could be taken based on your results (e.g., price change, cost reduction, investment).

10.2 Teacher’s Solution

Item	Amount (£)
Revenue (Sales)	85,000
Cost of Goods Sold (COGS)	45,000
Gross Profit	40,000
Operating Expenses	25,000
Operating Profit	15,000
Interest	1,500
Profit Before Tax	13,500
Tax (25 %)	3,375
Net Profit	10,125

Ratios

• Gross Profit Margin = (40,000 ÷ 85,000) × 100 = 47.1 % (healthy – good control of direct costs).
• Net Profit Margin = (10,125 ÷ 85,000) × 100 = 11.9 % (acceptable but could be improved by reducing overheads).

Possible managerial decision: Because the gross margin is strong but the net margin is pulled down by operating expenses, the manager could examine the £25,000 overheads and look for savings (e.g., renegotiating rent, reducing utilities, or streamlining admin staff). The resulting cost reduction would raise the net profit and improve the net profit margin.