Interpretation of data given on financial statements
Mo and Emma discuss profit margin
Financial information can help a business make judgements about current performance, performance against previous years, performance against competitors and performance from the perspective of a range of stakeholders. Assessing business performance is one of the main benefits of creating financial documents.
Comparing against previous years
Both income statements and statements of financial position can be compared over a number of years. For example they could compare 2017, 2018, 2019 and 2020 to see how the business has performed compared to each previous year. Businesses may want to measure key elements over several years, such as:
- Revenue made each year
- Gross and net profits
- Expenses
- Liabilities
- Assets
If in 2019, a desert-making business had a net profit of £10 million, and then in 2020 it had a net profit of £12 million; it can see there has been an improvement in the financial performance of the business. Similarly, a business may also notice that they were making less net profit than in previous years, which would highlight a decline in financial performance.
Comparison with competitors
Both income statements and statements of financial position can be compared with competitors. Businesses may be interested to see how their competitors are performing as a way of judging their own success. In the below example, it is clear to see thatFarhad’s Bakery has better financial performance better than Tim’s Bakery.
| Tim’s Bakery | Farhad’s Bakery | |
| Year | 2019 | 2019 |
| Revenue | £110,000 | £125,000 |
| Gross profit | £78,000 | £80,000 |
| Net profit | £25,000 | £28,000 |
| Year | |
| Tim’s Bakery | 2019 |
| Farhad’s Bakery | 2019 |
| Revenue | |
| Tim’s Bakery | £110,000 |
| Farhad’s Bakery | £125,000 |
| Gross profit | |
| Tim’s Bakery | £78,000 |
| Farhad’s Bakery | £80,000 |
| Net profit | |
| Tim’s Bakery | £25,000 |
| Farhad’s Bakery | £28,000 |
Performance from the perspective of stakeholders
A range of stakeholders such as shareholders, employees and suppliers will take a great interest in the financial performance of a business.
Shareholders are interested in how much profit has been made, along with reducing the overall expenses for a business where possible. Shareholders generally have an expectation that a business’ financial performance will improve each year to help them gain more from their investment.
Suppliers are interested in the financial performance of a business so that they can rely on payment from a business. In addition, if a business is making a huge amount of profit, a supplier may view this as an opportunity to try to increase its prices. If a business is making a loss, a supplier may begin to question whether a business will be able to continue purchasing supplies from them.
Employees may want to see the financial performance of a business for a number of reasons. Firstly, they may expect to receive a pay increase when a business is making large amounts of profit. Secondly, some employees may receive a share of business profits. Lastly, employees may become concerned about their job security if a business is consistently making a loss.
Profit
The profit made by a business is the money left over once all of the expenses incurred in running the business have been paid. Businesses usually separate their costs into variable costs and fixed costs. This means that a business can calculate two different types of profit, gross profit and net profit.
Gross profit margin
The gross profit margin is the percentage of sales revenue that is left once the cost of sales has been paid. It tells a business how much gross profit is made for every pound of sales revenue received. For example, a gross profit margin of 75% means that every pound of sales provides 75 pence of gross profit.
In order to calculate the gross profit margin, a business will use the following formula:
\(\text{Gross profit margin (\%)}=\frac{\text{Gross profit}}{\text{Sales revenue}} × 100\)
In the example given in the table above, the gross profit margins for this year and last year would be:
| Gross profit | Sales revenue | Gross profit margin (%) | |
| Last year | £50,000 | £150,000 | (£50,000 ÷ £150,000) × 100 = 33.33% |
| This year | £100,000 | £450,000 | (£100,000 ÷ £450,000) × 100 = 22.22% |
| Last year | |
| Gross profit | £50,000 |
| Sales revenue | £150,000 |
| Gross profit margin (%) | (£50,000 ÷ £150,000) × 100 = 33.33% |
| This year | |
| Gross profit | £100,000 |
| Sales revenue | £450,000 |
| Gross profit margin (%) | (£100,000 ÷ £450,000) × 100 = 22.22% |
This shows that the gross profit margin for this business decreased from 33.33% to 22.22% over this year, rounded to two decimal places.
Using the gross profit margin
Comparing gross profit margins over time can be useful for businesses. In the example above, the gross profit margin decreased despite the fact that the sales revenue tripled and gross profit doubled. This indicates that the cost of sales, which includes raw materials, increased faster than the business increased the price it charged its customers. This business might respond by increasing the price that it charges its customers or by negotiating lower prices for raw materials with its suppliers.
Net profit margin
The net profit margin is the proportion of sales revenue that is left once all costs have been paid. It tells a business how much net profit is made for every pound of sales revenue received. For example, a net profit margin of 32% means that every pound of sales provides 32 pence of net profit.
In order to calculate the net profit margin, a business will use the following formula:
\(\text{Net profit margin (\%)}=\frac{\text{Net profit}}{\text{Sales revenue}} × 100\)
For example, a business that knows its net profit and sales revenue can calculate its net profit margin as follows:
| Net profit | Sales revenue | Net profit margin (%) | |
| Last year | £30,000 | £150,000 | (£30,000 ÷ £150,000) × 100 = 20% |
| This year | £45,000 | £450,000 | (£45,000 ÷ £450,000) × 100 = 10% |
| Last year | |
| Net profit | £30,000 |
| Sales revenue | £150,000 |
| Net profit margin (%) | (£30,000 ÷ £150,000) × 100 = 20% |
| This year | |
| Net profit | £45,000 |
| Sales revenue | £450,000 |
| Net profit margin (%) | (£45,000 ÷ £450,000) × 100 = 10% |
This shows that the net profit margin for this business decreased from 20% to 10% over the past two years.
Using the net profit margin
Businesses can use the net profit margin to identify what is happening to their fixed costs. They can do this in two ways:
- Comparing the net profit margin with the gross profit margin - by comparing the net profit margin with the gross profit margin for the same time period, a business can identify how significant its fixed costs, or overheads, are. For example, a business that has a gross profit margin of 50% and a net profit margin of 10% knows that for every pound of goods sold, 40 pence is used to pay fixed costs. This can then be used to identify whether there is any scope to reduce these fixed costs.
- Comparing net profit margins over time - by comparing net profit margins over time, a business can identify what is happening to its costs. For example, a decrease in net profit margin indicates either that sales revenue has fallen faster than costs or that costs have increased faster than sales revenue.
