Evaluate Profitability in Business:- The presentation of the profit and loss account differs according to whether one is in French format of the individual accounts or in Anglo-Saxon format. Individual accounts under French standards impose a detailed classification of expenses by nature (consumption, wages, depreciation, etc.).
Evaluation of Profitability in Business
Anglo-Saxon standards impose a presentation by function (production, commercial, administrative, R & D). The IFRS standards and French regulation 99-02 applicable to the consolidated accounts of unlisted groups leave the choice between the two presentations. A number of listed groups opted for the presentation of expenses by nature (for example, the Bollore group).
This choice of presentation will obviously influence the analysis of profitability.
The presentation of the charges by function (or destination) obviously makes it possible to evaluate the performance of these functions. Evaluating the cost of each function as a percentage of sales makes it possible to monitor their performance, compared to other companies in the sector. Thus, the head of a company whose commercial expenses represent 16% of the turnover will question the performance if for its competitors, they represent only 12%.
The presentation of expenses by nature offers other advantages, it allows the external analyst to better identify the causes of variation of the result which are classified as “chisel effect” and “absorption effect of fixed charges”.
The Chisel Effect
It refers to a favorable or unfavorable evolution of a selling price compared to a purchase cost (goods or raw materials).
The table below illustrates a favorable scissors effect on the trading activity (increase in the commercial margin rate) and unfavorable on the industrial activity (decrease in the gross margin rate calculated from the consumption of raw materials).
Since the profit and loss account only shows financial data, its mere reading does not make it possible to identify the origin of the scissors effect: is the decline in the gross margin rate due to a fall in the selling price or to the increase not reflected in the selling p rice of a purchase cost?
It is then necessary to look for the origin of the chisel effect. A decrease in the gross margin rate may be due to:
- An increase in the cost of raw materials not reflected in the selling price,
- A decrease in the selling price motivated by a policy of taking market share,
- An unfavorable evolution the product mix,
- An adverse currency effect, etc.
The “Absorption of Fixed charges” Effect
Other, largely fixed, expense items (other purchases, personnel costs, depreciation, etc.) expressed as a percentage of sales should be analyzed. Thus, an increase in sales without a proportional increase in these expenses will result in an increase of the result more than proportional.
The interest of the presentation by nature is to be able to locate a chisel effect in the pure state, by observing the rate of commercial or gross margin. On the other hand, in the income statement by function of an industrial enterprise, a scissors effect can be masked by other causes of change in the result such as factory productivity gains or a lower absorption of fixed production costs.
The opinion of the French company of financial analysts (SFAF)
By a declaration of February 26, 2008, this association which brings together the stock market analysts expressed its needs in terms of financial information. It recognized the central place of the income statement in that it allows, in principle, to obtain a medium and long term vision.
She also expressed a strong preference for presentation by nature in order to interpret the variations in results more clearly. Analysts want detailed information on operating revenues and expenses.
They want to be able to isolate non-recurring items from the operating result. As for the financial result, they want to be able to separate the interest charges from the other expenses (cost of the debt) that allow the norms IFRS.