When trying to understand a business model, nothing reveals more than a profit and loss statement. It highlights areas of improvement, development and opportunity proven to run business operations smoothly.
What is a Profit & Loss Statement?
A set of financial statements comprises balance sheet, profit & loss statement, cash flow statement and statement of changes in equity.
All publicly owned companies are mandated to prepare and publish financial statements at the end of every financial year.
Profit & Loss Statement is often known as the income statement, or statement of operations summarises a company’s financial performance over a specific period, usually a quarter or fiscal year. The statement communicates a company’s ability to generate revenue, manage expenses and create profits.
It provides information on the total revenue and other income generated during a period and the expenses incurred to generate that revenue and other income.
The P&L also allows investigating the revenue and expense trends, cash flow, net income and overall profitability of the company basis which the entity can use resources and budgets accordingly.
The basic equation underlying the income statement is:
Revenue + Other Income – Expenses = Income – Expenses = Net Income
To further understand the profit & loss statement, it is vital to assess its components.
Components of a Profit & Loss Statement
Based on the type of business and nature of operations, the components of an income statement are:
Revenue, also referred to as sale or turnover, is the total amount generated from the delivery of goods or services during the ordinary course of business. It is a summation of a business’s multiple revenue streams presented at the top of the income statement.
Expenses or cost of goods sold depicts the costs directly tied to a product or service, including outflows such as labour, raw materials, other expenses. The cost of goods sold is called the cost of sales in a service-oriented company.
Gross profit is a crucial metric as it shows the amount remaining after incurring the direct cost of producing a product or service, thus showcasing if a company’s manufacturing process needs to be cost-effective compared to its revenue. Gross profit margin is a metric of profitability that shows gross profit as a percentage of revenue and helps analyse the amount of money left after production.
These are expenses incurred during normal business operations such as marketing, advertising and promotion expenses, salaries incurred, rent payments, selling and distribution expenses, general and administrative expenses.
Depreciation and amortisation are non-cash expenses allocated to the cost of an asset over its useful life. It is the reduction in the value of an asset over a specified period.
Operating profit is the total earnings generated from core business functions after deducting operational expenses incurred during a given period. The operating profit margin ratio depicts how well a company has been utilising its resources to generate profit.
Interest expense is a non-operating expense incurred by an entity on the funds borrowed. It is deducted from the operating profit of a company to arrive at the Earnings before tax. When analysing the income statement, it is essential to check if the debt borrowed is increasing year on year, thus increasing the company’s interest expenses.
Other income is the income not generated from the core business activities. It includes rent received, gains resulting from the sale of assets, interest received. It is essential for a company to earn profits from its core business; however, if the company is generating profits due to other income when its primary operations are suffering losses, it would be a red flag indication to the investors.
The last element on the profit and loss account is the relevant taxes charged on the income before tax. The total tax expenses include the current taxes and future tax liabilities.
Net income is the total earnings of a company after factoring deductions and taxes in pretax income. It is significant to an investor as it highlights the amount available with the company for paying dividends, repurchasing shares, reinvesting in the business or maintaining it as retained earnings.
Significance of a Profit & Loss Statement
Below are pointers on the significance of the profit and loss statement:
- The profit and loss statement is widely used in fundamental analysis enabling traders to gauge the worth of a certain company’s stock as it gives insights into if the business is being run profitability.
- It gives an analyst an understanding of the financial strength of a company, attractiveness of investing in it or acquiring the business.
- The profit and loss statement offers a detailed record of how a company’s revenue and expense is recognised.
- A company’s owners can better understand their financial standing and review business operations at regular intervals.
Profit and loss statement analysis can be carried out considering the below:
- Comparing year on year numbers and industry benchmarking
- Analysis of ratios such as gross profit margin, EBITDA margin, operating profit margin, pretax margin, net profit margin. If it is increasing, the company is becoming more efficient.
- Trend analysis to understand if the statement is improving or deteriorating
- Assess the payment of interest expense; if it increases, check the utilisation of debt and repayment schedule for the same.
- Check if the company is showing lower depreciation to boost their profits
- One Negative profit and loss statement can be seen as a warning sign, while successive losses mean there is a fundamental issue in the operations. However, one negative profit and loss statement may not deter investors if they view strong long term potential in the business.
The core concept and understanding of the Income statement provides a bundle of information on the business operations.