Analysing financial performance

The Income Statement (Profit and Loss Account)

The income statement (also called the profit and loss account) summarises a business's revenues and costs over a trading period to show the profit or loss made. AQA requires students to understand its key components and what they reveal about financial performance.

• Revenue — total income from sales before any deductions.
• Cost of goods sold (COGS) — the direct costs of producing the goods sold: raw materials, direct labour, packaging. These are the variable costs directly tied to what was sold.
• Gross profit = Revenue − Cost of goods sold. It shows how much the business made from its core trading activity before any overheads are deducted.
• Operating expenses — indirect costs of running the business: wages (non-production), rent, utilities, marketing, administration. These correspond to fixed costs and overheads.
• Net profit = Gross profit − Operating expenses. The "bottom line" — what the business actually earned after all costs are deducted.

Profitability Ratios

Raw profit figures are limited for comparison — a £70,000 profit is meaningless without knowing the revenue it was generated from. Profitability ratios express profit as a percentage of revenue, enabling fair comparison between businesses of different sizes and between different periods for the same business.

Gross Profit Margin (GPM)

Gross profit margin (%) = (Gross profit ÷ Revenue) × 100

GPM measures the percentage of revenue retained after the direct costs of production are deducted. A higher GPM indicates the business is producing efficiently relative to its sales price. GPM varies significantly by industry — retailers typically operate at lower GPMs than manufacturers or software businesses.

Example: GPM = (£180,000 ÷ £500,000) × 100 = 36%

This means for every £1 of revenue, 36p remains after covering direct production costs — available to cover overheads and generate net profit.

Net Profit Margin (NPM)

Net profit margin (%) = (Net profit ÷ Revenue) × 100

NPM measures the percentage of revenue retained as profit after all costs — both production costs and overheads — are deducted. It is the most complete measure of overall profitability. A higher NPM means the business converts a higher proportion of its revenue into profit.

Example: NPM = (£70,000 ÷ £500,000) × 100 = 14%

This means for every £1 of revenue, 14p is kept as net profit after all costs.

Interpreting Changes in Margins

• A falling GPM suggests the cost of production is rising faster than selling prices — the business may need to renegotiate supplier prices, find cheaper inputs, or raise prices.
• A falling NPM with stable GPM suggests overheads (rent, wages, marketing) are increasing — the business needs to control operating expenses.
• A rising NPM indicates improving overall efficiency — the business is retaining more of each pound of revenue as profit.
• Comparing margins between two businesses reveals which is operating more efficiently relative to its revenue, independent of size.