2.1.3 · 40–60 minutes · read, calculate, discuss, review
What you will learn
- Build a bridge from revenue to profit.
- Distinguish operating performance from financing and tax.
- Calculate earnings per share under explicit assumptions.
2.1 · Financial Statements
Financial Statements
Financial Statements · the work you will do
- 1Find the source
- 2Read the profit
- 3Follow the cash
- 4Test the forecast
Before you begin
A fictional company sells more products but earns less profit. Which lines of its income statement could explain the change?
Write your first response before continuing.
Video coming soon · about 3 minutes
The Income Statement: Part 1
Use the narration below while the recording is being made, then try the decisions in this lesson.
Read the full narration
Welcome to On Judgement. A fictional company sells more products but earns less profit. Which lines of its income statement could explain the change? Take a first view. You can change it when you have considered the evidence.
Revenue less cost of sales gives gross profit. Deduct operating expenses to reach operating profit in our simplified presentation. Net finance costs and tax then lead to profit for the year. Real statements include additional lines and definitions; use their labels and reconciliation. Revenue is earned activity, not necessarily cash collected. Expenses are recognised costs, not necessarily cash paid during the same period.
Cost of sales and operating expenses are accounting groupings. They are not identical to variable and fixed costs: production overhead can be fixed, and selling expenditure can vary with demand. Read the policies and business model before comparing two margins. Depreciation may already be included within cost of sales or operating expenses; do not deduct it again simply because a separate note lists it.
Interest reflects financing as well as business performance. The income-tax expense may differ from tax cash paid. Profit attributable to ordinary shareholders, divided by the relevant weighted-average share count, gives basic EPS. Dilution can change the denominator and sometimes the numerator. Use a stated simplified share count here; later real-company work requires checking the earnings and share definitions.
Management may remove an unusual cost from an adjusted measure. Reconcile adjusted profit back to the reported statement, ask whether excluded items recur and assess their cash or economic cost. An expense called exceptional still matters to owners. A clear bridge is more informative than choosing whichever measure gives the most attractive margin or growth story.
Let's work through Harbour’s profit bridge · all figures £m. Revenue 240; cost of sales 144; operating expenses 60, including depreciation 6; net finance cost 4; income-tax expense 8. There are 20m ordinary shares throughout the year, with no preference claims or dilution. Pause here and try the calculation or reasoning before continuing.
Gross profit = 240 − 144 = 96. Operating profit = 96 − 60 = 36; simplified EBITDA = 36 + 6 = 42. Profit before tax = 36 − 4 = 32; profit for the year = 32 − 8 = 24. Basic EPS = £24m ÷ 20m = £1.20, or 120p.
EBITDA is not cash flow: working capital, investment, tax and financing still need investigation.
Now try the choices in this lesson. If your answer changes, identify the reason. Calculate earnings per share under explicit assumptions. Use the case activities to put the idea into your own words, and return to the evidence when more than one conclusion is defensible.
Follow the profit bridge
Revenue less cost of sales gives gross profit. Deduct operating expenses to reach operating profit in our simplified presentation. Net finance costs and tax then lead to profit for the year. Real statements include additional lines and definitions; use their labels and reconciliation. Revenue is earned activity, not necessarily cash collected. Expenses are recognised costs, not necessarily cash paid during the same period.
Understand what sits in each line
Cost of sales and operating expenses are accounting groupings. They are not identical to variable and fixed costs: production overhead can be fixed, and selling expenditure can vary with demand. Read the policies and business model before comparing two margins. Depreciation may already be included within cost of sales or operating expenses; do not deduct it again simply because a separate note lists it.
From business performance to shareholders
Interest reflects financing as well as business performance. The income-tax expense may differ from tax cash paid. Profit attributable to ordinary shareholders, divided by the relevant weighted-average share count, gives basic EPS. Dilution can change the denominator and sometimes the numerator. Use a stated simplified share count here; later real-company work requires checking the earnings and share definitions.
Separate reported and adjusted results
Management may remove an unusual cost from an adjusted measure. Reconcile adjusted profit back to the reported statement, ask whether excluded items recur and assess their cash or economic cost. An expense called exceptional still matters to owners. A clear bridge is more informative than choosing whichever measure gives the most attractive margin or growth story.
Harbour’s profit bridge · all figures £m
Follow Harbour’s profit bridge
Where are finance costs and tax reflected in this bridge?
Revenue 240; cost of sales 144; operating expenses 60, including depreciation 6; net finance cost 4; income-tax expense 8. There are 20m ordinary shares throughout the year, with no preference claims or dilution.
- Gross profit = 240 − 144 = 96.
- Operating profit = 96 − 60 = 36; simplified EBITDA = 36 + 6 = 42.
- Profit before tax = 36 − 4 = 32; profit for the year = 32 − 8 = 24.
- Basic EPS = £24m ÷ 20m = £1.20, or 120p.
EBITDA is not cash flow: working capital, investment, tax and financing still need investigation.
Put it into practice
1. Rebuild the bridge
Write every calculation from revenue to profit for Harbour without looking at the worked solution. Identify where depreciation is already included.
Record your response in your workbook before opening feedback.
Compare with a model response
240 − 144 = 96; 96 − 60 = 36; 36 − 4 = 32; 32 − 8 = 24. Depreciation is included in the £60m operating expenses and must not be deducted twice.
2. Read an adjustment
Management calls £3m of the £60m expenses a restructuring cost and reports adjusted operating profit £39m. What should an investor ask?
Record your response in your workbook before opening feedback.
Compare with a model response
The arithmetic reconciles to reported £36m. Ask whether restructuring repeats, what cash payments remain, why the cost arose, and whether forecast savings are credible. Keep both reported and adjusted measures.
3. Explain EPS
Profit stays £24m but the weighted-average ordinary share count rises to 24m. Calculate EPS and explain why the old EPS cannot simply be reused.
Record your response in your workbook before opening feedback.
Compare with a model response
EPS becomes £1.00. More claims share the same profit. Investigate what the new capital funded and its future return before calling dilution good or bad.
Jargon buster
Revenue
Income from the business’s relevant activities, under its recognition rules.
Gross profit
Revenue less cost of sales.
Operating profit
Profit after operating expenses in the stated presentation.
EBITDA
Earnings before interest, tax, depreciation and amortisation; definitions require checking.
EPS
Earnings per share under the specified numerator and denominator.
Adjusted profit
A modified profit measure requiring reconciliation.
Knowledge check
Make each choice on the page. Feedback explains the reasoning. Use Try again after revisiting an idea.
AQA connection and further reading
AQA 7138: 3.1.4 financial management; Annexes 6–7 quantitative skills/formulae; AO2 application, AO3 analysis and AO4 evaluation. Detailed accounting policies, EPS and investment multiples are investing enrichment where used.
AQA 7138 specification
Primary curriculum mapping; teacher interpretation, not endorsement.
IAS 7 overview · IFRS Foundation
Accounting classification context. Presentation changes and effective/adoption dates must be checked for real reports.
Free Cash Flow Valuation · CFA Institute
Technical cross-check for consistent claims and valuation formulas; advanced optional reading.
Introduction to Valuation · Aswath Damodaran, NYU
Optional deeper reading on valuation approaches.
Take forward
Build a bridge from revenue to profit. Distinguish operating performance from financing and tax. Calculate earnings per share under explicit assumptions.