the meaning and purpose of the statement of profit or loss

10.1 Financial Statements – Statement of Profit or Loss (Income Statement)

1. Objective

To understand the meaning, statutory basis, purpose and structure of the Statement of Profit or Loss (SPL), how it links to the Statement of Financial Position, and how it is used by internal and external users of financial information.

2. What is the Statement of Profit or Loss?

• Definition: A financial statement that records a company’s revenue, expenses and the resulting profit or loss for a defined period (usually a year or a quarter).
• Statutory requirement: Mandatory under UK GAAP (FRS 102) and IFRS (IAS 1) as part of a complete set of financial statements.

Net Profit (Loss) = Total Revenue – Total Expenses

3. Primary Purposes

• Assess the profitability of the business during the reporting period.
• Provide information for managerial planning, control and strategic decision‑making.
• Supply external users (investors, lenders, suppliers, tax authorities, employees) with evidence of the firm’s ability to generate earnings and meet obligations.
• Form the basis for calculating retained earnings that appear in the Statement of Financial Position.
• Explain the movement in equity from one balance‑sheet date to the next (see Section 11).

4. Key Components – Definitions & Typical Items

1. Revenue (Sales) – Total inflow from the entity’s core activities before any deductions.
   • Typical items: cash sales, credit sales, service fees, interest income (if part of core business).
2. Cost of Sales (Cost of Goods Sold – COGS) – Direct costs attributable to the production of goods sold or services delivered.
   • Typical items: raw materials, direct labour, production overheads (e.g., factory utilities).
3. Gross Profit – Revenue less Cost of Sales.
4. Operating Expenses – Costs of running the business that are not directly tied to production.
   • Salaries & wages (administrative), rent, utilities, advertising, depreciation, amortisation, research & development, insurance.
5. Operating Profit (EBIT) – Earnings before interest and tax; Gross Profit less Operating Expenses.
6. Interest Expense – Cost of borrowing (interest on loans, bonds, overdrafts).
7. Profit Before Tax (PBT) – Operating Profit less Interest Expense (and any other non‑operating items such as gains/losses on disposals).
8. Tax Expense – Current corporation tax payable on profit before tax.
9. Net Profit (or Net Loss) – Final profit after all expenses, interest and tax have been deducted.

5. Inventory Valuation – Net Realisable Value (NRV)

For the SPL, inventory must be valued at the lower of cost and Net Realisable Value (NRV). NRV is the estimated selling price less estimated costs of completion and disposal.

Item	Cost (£)	Estimated Selling Price (£)	Estimated Disposal Costs (£)	NRV (£)	Value Used (£)
Finished goods A	12,000	15,000	1,500	13,500	12,000 (cost lower)
Finished goods B	8,000	9,000	300	8,700	8,700 (NRV lower)

Only the lower amount is recorded in Cost of Sales.

6. Depreciation – Straight‑Line Method (required for the exam)

Only the straight‑line method is examined in Cambridge 9609.

Formula:
Depreciation expense per year = (Cost of asset – Residual value) ÷ Useful life (years)

Example: A machine costs £30,000, has a residual value of £5,000 and a useful life of 5 years.

• Depreciation = (£30,000 – £5,000) ÷ 5 = £5,000 per year.
• The £5,000 is recorded as an operating expense in the SPL.

7. Cost Classifications & Costing Methods

Classification	Definition	Examples
Direct costs	Costs that can be traced directly to a product or service.	Raw material, direct labour.
Indirect costs	Costs that cannot be traced directly; allocated to products.	Factory overhead, administration.
Fixed costs	Do not vary with output.	Rent, salaries of permanent staff.
Variable costs	Vary directly with output.	Raw material, direct labour (hourly).

Full (Absorption) Costing: All production costs (direct + indirect + fixed) are absorbed into the cost of each unit. Used for external reporting.

Contribution (Marginal) Costing: Only variable production costs are assigned to units; fixed production costs are treated as period expenses. Useful for internal decision‑making (break‑even analysis, pricing).

8. Typical Layout of a Statement of Profit or Loss

Item	Amount (£)
Revenue (Sales)	500,000
Cost of Sales	300,000
Gross Profit	200,000
Operating Expenses	120,000
Operating Profit (EBIT)	80,000
Interest Expense	10,000
Profit Before Tax (PBT)	70,000
Tax Expense (30 %)	21,000
Net Profit	49,000

9. Amendments to a Statement of Profit or Loss

Changes in accounting policy, errors, or one‑off events may require the SPL to be restated.

Original SPL (£)	Amended SPL (£)	Reason for Amendment
Revenue 500,000 Cost of Sales 300,000 Gross Profit 200,000 Operating Expenses 120,000 Operating Profit 80,000 Interest 10,000 PBT 70,000 Tax (30 %) 21,000 Net Profit 49,000	Revenue 500,000 Cost of Sales 285,000 Gross Profit 215,000 Operating Expenses 125,000 Operating Profit 90,000 Interest 10,000 PBT 80,000 Tax (30 %) 24,000 Net Profit 56,000	Change in depreciation method increased depreciation by £5,000 and re‑classified £15,000 of overheads from COGS to operating expenses.

10. “What‑If” Impact Analysis

Using the original figures above, calculate the effect of the following changes.

1. Sales increase by 10 %.
2. Cost of Sales falls by 5 % (improved efficiency).

Scenario	Revenue (£)	Cost of Sales (£)	Gross Profit (£)	Operating Profit (£)	Net Profit (£)
Original	500,000	300,000	200,000	80,000	49,000
+10 % Sales	550,000	300,000	250,000	130,000	79,000
-5 % COGS	500,000	285,000	215,000	95,000	58,500
Both changes	550,000	285,000	265,000	145,000	87,500

11. Link to the Statement of Financial Position (Balance Sheet)

• Net profit for the period is added to Retained Earnings (or deducted if a loss) in the equity section of the Statement of Financial Position.
• Dividends declared (but not yet paid) are subtracted from retained earnings after the SPL is prepared.
• Thus, the SPL explains the movement in equity from one balance‑sheet date to the next.

12. Limitations of the Statement of Profit or Loss

• Prepared on an accrual basis – does not show actual cash inflows/outflows.
• Historical cost accounting may undervalue assets and distort profit (e.g., revaluation gains are excluded).
• Non‑operating items (one‑off gains/losses, tax adjustments) can obscure core operating performance.
• Subject to management’s accounting estimates (depreciation, provisions) which involve judgment.
• Only covers a single period; trend analysis is required for a fuller picture.

13. Ratios Derived from the Statement of Profit or Loss

These ratios are examined in Cambridge 9609 and help interpret raw figures.

Ratio	Formula	Interpretation
Gross Profit Margin	(Gross Profit ÷ Revenue) × 100 %	Measures efficiency of production/purchasing.
Operating Profit Margin	(Operating Profit ÷ Revenue) × 100 %	Shows profitability after covering operating costs.
Net Profit Margin	(Net Profit ÷ Revenue) × 100 %	Overall profitability after all expenses.
Earnings per Share (EPS)	(Net Profit – Preferred Dividends) ÷ Shares Outstanding	Profit attributable to each ordinary share.
Current Ratio (Liquidity)	Current Assets ÷ Current Liabilities	Ability to meet short‑term obligations.
Acid‑Test (Quick) Ratio	(Current Assets – Inventories) ÷ Current Liabilities	Liquidity excluding inventory.
Return on Capital Employed (ROCE)	Operating Profit ÷ (Total Assets – Current Liabilities) × 100 %	Efficiency of capital utilisation.
Inventory Turnover	Cost of Sales ÷ Average Inventory	How many times inventory is sold and replaced in a period.
Gearing Ratio	Long‑term Debt ÷ (Long‑term Debt + Equity) × 100 %	Proportion of finance supplied by creditors.
Dividend Yield	Dividend per Share ÷ Market Price per Share × 100 %	Return to shareholders from dividends.

14. Cash‑Flow Forecasts (Link to the SPL)

Although cash‑flow statements are a separate financial statement, the SPL provides the basis for forecasting cash inflows and outflows.

Cash‑flow Category	Typical Sources / Uses
Operating cash‑inflows	Cash sales, collection of credit sales, interest received (if operating).
Operating cash‑outflows	Payments to suppliers (COGS), wages, rent, tax payments, interest paid.
Investing cash‑flows	Purchase or sale of plant & equipment (linked to depreciation), investment in securities.
Financing cash‑flows	Proceeds from loans or issue of shares, dividend payments, repayment of borrowings.

Simple cash‑flow forecast example (quarterly):

Quarter	Cash In (£)	Cash Out (£)	Net Cash Flow (£)
Q1	120,000	95,000	25,000
Q2	130,000	100,000	30,000
Q3	115,000	90,000	25,000
Q4	140,000	110,000	30,000

Operating cash‑flows are derived from the SPL figures (e.g., sales, COGS, operating expenses, tax and interest).

15. Preparing the Statement – Step‑by‑Step Checklist

1. Collect all revenue figures for the period (sales invoices, service contracts, etc.).
2. Value opening inventory and calculate closing inventory at the lower of cost and NRV; determine Cost of Sales.
3. Derive Gross Profit (Revenue – Cost of Sales).
4. Identify and total all Operating Expenses, including straight‑line depreciation.
5. Compute Operating Profit (EBIT) = Gross Profit – Operating Expenses.
6. Adjust for non‑operating items (gains/losses, interest expense) to obtain Profit Before Tax.
7. Apply the appropriate corporate tax rate to calculate Tax Expense.
8. Subtract Tax Expense to arrive at Net Profit (or Net Loss).
9. Link Net Profit to Retained Earnings in the Statement of Financial Position and record any dividends declared.
10. Review the SPL for compliance with FRS 102/IAS 1 presentation requirements and for any required disclosures.

16. Summary

The Statement of Profit or Loss is a compulsory financial statement that records a company’s ability to generate profit over a defined period. It details revenue, cost of sales, operating expenses, interest, tax and the resulting profit. Mastery of its structure, the required inventory valuation (NRV), straight‑line depreciation, cost classifications, and the link to the balance sheet is essential for Cambridge A‑Level Business (9609). In addition, students must be able to calculate and interpret a full set of profitability, liquidity, efficiency and gearing ratios, and understand how the SPL feeds into cash‑flow forecasts.

17. Glossary of Key Terms

Revenue (Sales)

Total inflow from ordinary activities before any deductions.

Cost of Sales (COGS)

Direct costs of producing the goods or services sold.

Gross Profit

Revenue – Cost of Sales.

Operating Expenses

All expenses incurred in the normal course of business other than COGS (e.g., admin, rent, depreciation).

Operating Profit (EBIT)

Gross Profit – Operating Expenses.

EBITDA

Earnings before interest, tax, depreciation and amortisation; useful for comparing operating performance.

Interest Expense

Cost of borrowing.

Profit Before Tax (PBT)

Operating Profit – Interest Expense ± non‑operating items.

Tax Expense

Current corporation tax payable on PBT.

Net Profit (or Net Loss)

Final profit after all expenses, interest and tax have been deducted.

Net Realisable Value (NRV)

Estimated selling price less estimated costs of completion and disposal; used to value inventory.

Straight‑Line Depreciation

(Cost – Residual value) ÷ Useful life.

Gross Profit Margin

(Gross Profit ÷ Revenue) × 100 %.

Operating Profit Margin

(Operating Profit ÷ Revenue) × 100 %.

Net Profit Margin

(Net Profit ÷ Revenue) × 100 %.

Earnings per Share (EPS)

(Net Profit – Preferred Dividends) ÷ Shares Outstanding.

Current Ratio

Current Assets ÷ Current Liabilities.

Acid‑Test Ratio

(Current Assets – Inventories) ÷ Current Liabilities.

ROCE

Operating Profit ÷ (Total Assets – Current Liabilities) × 100 %.

Inventory Turnover

Cost of Sales ÷ Average Inventory.

Gearing Ratio

Long‑term Debt ÷ (Long‑term Debt + Equity) × 100 %.

Dividend Yield

Dividend per Share ÷ Market Price per Share × 100 %.