A Guide to Reading and Analyzing Profit and Loss Statements (P&L)

The P&L serves as a crucial instrument, providing a snapshot of a company's financial performance over a specific period. Understanding this fundamental financial document is essential for investors, analysts, and business owners as it unveils the story behind the numbers and illuminates the path to profitability.

In this article, I will take you on a journey to unwrap the intricacies of the P&L. I will also help you explore the significance of each section so that you are well equipped with the skills to understand the narrative embedded into the financial figures.

A P&L is a financial report that provides a summary of a company’s revenues, expenses, and profits/losses over a given period of time. The P&L statement shows a company’s ability to generate sales, manage expenses, and create profits. It is prepared based on accounting principles that include revenue recognition, matching, and accruals.

In other words, it is a statement that summarizes the total impact of revenue, expenses , gains and loss for a specific period of time and how profitable a business is.

It contains information about how a company is earning its revenue and where the company is spending it.

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?Revenue/ Sales

Revenue is the money generated from normal business operations, calculated as the average sales price by the number of units sold. It is also called as the top line in business terms.

Typical Revenue Includes:

??Net sales: represent the total revenue generated by a business through the sale of its products or goods. It is the amount of money a company earns from selling its core products, excluding any returns, discounts, or allowances.

Example: If a company sells Rs 1,00,000 worth of Cookies and allows returns or discounts amounting to Rs 10,000, the net sales would be Rs 90,000 (Rs 100,000 – Rs 10,000).

??Service revenue: refers to the income earned by a business through the provision of services rather than the sale of goods. This category Includes fees charged for various services offered by the business.

Example: If a consulting firm charges clients Rs 50,000 for its advisory services, that Rs 50,000 would be recorded as service revenue in the Profit and Loss Statement.

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Two significant concepts in revenue that aids in a thorough understanding are unearned revenue and accrued revenue.?

??Accrued revenue: It is the revenue earned by a company for the delivery of goods or services that is yet to be paid by the customer. In accrual accounting, revenue is reported when the ownership of goods is transferred and may not necessarily represent cash in hand. This in general terms is denoted as debtors.

??Deferred, or unearned revenue: It can be thought of as the opposite of accrued revenue, It includes money prepaid by a customer for goods or services that is yet to be delivered. If a company has received prepayment for its goods, it would recognize the revenue as unearned, but would not recognize the revenue on its income statement until the period for which the goods or services has been delivered. This is generally called as advance from customers.

Revenue and income are sometimes used interchangeably. However, these two terms do usually mean different things. Revenue is used to measure the total amount of sales a company generates from its goods and services. Income incorporates expenses and report the net proceeds a company has earned.

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? Expenses

Logically it is the money that the company spends during a reporting period.

?? Direct: A direct cost is a price that can be directly associated to the production of specific goods or services. In the case of company like UNIBIC, that might be Maida, butter, Sugar, any items directly related to producing Cookies.

?? Indirect: These expenses are not traceable to the production of a product. It can include overhead costs like rent, maintenance, electricity bills, etc. You don’t include these in COGS.

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?? Cost of goods sold: This line item includes direct cost associated with sale of products to generate income. This is invariably the raw material cost that the company requires to manufacture finished goods. Other costs included are those that are directly tied to the production of the products, including the cost of Labor and manufacturing overhead.

In companies whose main revenue comes from sell of services, it is referred as “cost of sales”.

Understanding the cost of goods sold helps you to estimate a company’s bottom line. If COGS increases, net income will decrease. Businesses thus try to keep their COGS low so that net profits will be higher.

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?Gross profit.

It is calculated by deducting the cost of goods sold from the sales revenue.

Gross profit should not be confused with operating profit. Operating profit is calculated by subtracting operating expenses from gross profit. (Explained later).

Not including fixed costs like rent and insurance, gross profit highlights the effectiveness of resource utilization.

This metric normally looks at variable costs that fluctuates with the level of output.

However, sometimes a portion of fixed costs is assigned to each unit of production under absorption costing, required under GAAP. For instance, If a factory produces 10,000 packets of cookies, and the company pays Rs 30,000 in rent for the building, a cost of Rs 3 would be attributed to each packet under absorption costing.

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To assess the gross profit of a business, a comprehensive approach involving several key methodologies is recommended:

1??Analyze trends in gross profit margins over different periods. Consistently high or increasing margins may indicate effective cost management and pricing strategies and vice versa.

2??Compare the company's gross profit margin to industry benchmarks. Understanding how the company performs relative to others which provides context and insight into its competitive position.

3??Evaluate the contribution of each product or service to the overall gross profit. Some products may have higher margins than others, impacting the overall profitability of the business.

4??Break down the components of COGS, such as materials, labor, and overhead. Identify any significant changes in these costs and investigate the underlying reasons.

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?Marketing, advertising and promotion expenses.

These are the expenses that relates to promotion and advertising to generate revenue for the business. Advertising costs will in most cases fall under sales, general, and administrative (SG&A) expenses.

They are sometimes recorded as prepaid expenses on the balance sheet and then moved to the income statement when sales that are directly related to those costs come in.

A good metric to analyze Marketing expenses is the advertising to sales ratio.

It can be used to measure the effectiveness of a specific product launch. It is also a measure of how successful a company’s advertising strategies are. It is calculated by dividing total advertising expenses by sales revenue.

It is important to note that there is no ideal advertising to sales ratio – it depends on the industry. Therefore, when determining whether a company’s advertising to sales ratio is high or low, it is important to compare the figure to the industry average.

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?Selling, general and administrative expenses (SG&A)

These are the cost directly associated with the running of the business.

It includes all everyday operating expenses of running a business that are not included in the production of goods or delivery of services.

Many SG&A line items, such as rent and base salaries, are fixed costs that must be paid regardless of production or sales volumes.

Other SG&A costs, such as distribution costs, are variable and typically change as sales volumes rise or fall. Still others may be semi-variable, including base costs plus an additional cost component that varies based on usage.

In other words, these are also called the operating expenses.

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?Operating Income:

It is calculated as EBIT (Earnings before Interest and taxes)

Operating Income= Gross profit- Operating expenses.

Or, Operating income = Gross Profit – Operating Expenses – Depreciation – Amortization

Or, Operating income = Net Earnings + Interest Expense + Taxes

?Operating income is considered a critical indicator of how efficiently a business is operating. You can closely monitor operating profit in order to assess the trend of a company’s efficiency over a period of time.

The higher the operating profit, the more effectively a company’s core business is being carried out.

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?? EBIDTA (Earnings before interest depreciation and Taxes)

EBIDTA= Gross profit- SG&A Expenses (other than depreciation).

It generally is not a metric recognized under GAAP. However, some public companies report EBITDA in their quarterly results.

It can be used to track and compare the profitability of companies regardless of their depreciation assumptions or financing arrangements.? It is widely used in the analysis of asset-intensive industries with a lot of PPE and correspondingly high non-cash depreciation costs. In those sectors, the costs that EBITDA excludes may obscure changes in the underlying profitability—for example, Airport Operators.

Since, EBITDA is a non-GAAP measure, the way it is calculated can vary from one company to the next. It is not uncommon for companies to emphasize EBITDA over net income because the former makes them look better.

An important red flag for you can happen when companies have borrowed heavily or are experiencing rising capital and development costs. In those cases, EBITDA may serve to distract investors from the company's challenges.

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How to analyze a profit and loss statement?

There exists a diverse range of analytical tools to comprehensively assess a Profit and Loss (P&L) statement. Employing a multi-faceted approach enhances the depth and accuracy of financial analysis. Some key tools includes:

??Vertical Analysis:

It is a method of analyzing the financial statements where each line items is listed as a percentage of a base figure within the statement.

Thus, line items on an income statement can be stated as a percentage of gross sales.

By showing the various expense line items in the income statement as a percentage of sales, one can see how these are contributing to profit margins and whether profitability is improving over time.

It thus becomes easier to compare the profitability of a company with its others.

It is specially convenient to perform when you are analyzing on the comparative basis.

?? Horizontal Analysis

It is the comparison on the changes in the amount of various items in the financials statements over multiple reporting periods which allows to see what has been driving a company's financial performance over several years and to spot trends and growth patterns.

This type of analysis enables to assess relative changes in different line items over time and project them into the future.

The analysis of critical measures of business performance, such as profit margins, inventory turnover, and return on equity, can detect emerging problems and strengths.

For example, earnings per share (EPS) may have been rising because COGS has been falling or because sales have been growing steadily.

The identification of trends and patterns is driven by asking specific. For example, the management may ask "how did each geographical region improved sales over the past four quarters?".

This type of question guides itself to selecting certain horizontal analysis methods and specific trends or patterns to seek out.

It can expressed as a percentage or an absolute amount.

?? Ratio Analysis.

Ratio analysis help to consolidate the various bits of a financials statement in easily understandable format.

Following are the few ratios which are normally used when a profit and loss statement is to be analyzed.

1?? Gross profit Margin: (Gross profit/ Revenue or sales)

This reflects the total income earned by a business after deducting the cost of producing it.

2??Net profit Margin: (Net Income/ Revenue or sales)

It measures the income generated by each rupees of sales.

?3??Operating profit Margin: (EBIT/ Revenue or sales)

?It is a profitability or performance ratio that reflects the percentage of profit a company produces from its operations before subtracting taxes and Interest charges.

I personally feel that, EBITDA is a better tool to compare than EBIT as it truly shows the operating income generated by the company.

?4??Debt service coverage ration (Operating Income/ Debt Service)

?It is the ratio that shows the percentage of operating income available for debt service( Interest as well as the principal payments).

DSCR measures a firm's available cash flow to pay current debt obligations. It is a crucial indicator of a company's cash flow health and its likelihood to qualify for a loan.

Various Lenders use DSCR to assess a borrower's ability to cover debt service costs. A DSCR of 1 denotes just enough operating income to meet debt obligations, while a DSCR of 0.95 implies that only 95% of annual debt payments can be covered by net operating income.

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5??Return on assets: ( Net Income/ total assets)

It reveals the after tax profit a company generates from every rupees of assets it holds.

A higher ROA means a company is more efficient and productive at managing its balance sheet to generate profits while a lower ROA indicates there is room for improvement.

?One of the biggest issues with ROA is that it can't be used across industries. That’s because companies in one industry have different asset bases than those in another. So the asset bases of companies within the Chemical industry aren't the same as those in the retail industry.

Thus, ROA is most useful for comparing companies in the same industry, as different industries use assets differently and A ROA of over 5% is generally considered good and over 20% excellent.

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6??Return on equity: ( Net Income/ Equity)

It measures the rate of return on the money that equity investors have put into the business.

Net income is calculated before dividends paid to common shareholders and after dividends to preferred shareholders and interest to lenders.

?Whether an ROE is deemed to be good or bad will depend on what is normal among a competitors. A good rule of thumb is to target an ROE that is equal to or just above the average for the company's sector (those in the same business).

?The first potential issue with a high ROE could arise where there is inconsistent profits.

Second issue that could cause a high ROE is excess debt. If a company has been borrowing aggressively, it can increase ROE because equity is equal to assets minus debt. The more debt a company has, the lower equity can fall. This can inflate earnings per share (EPS), but it does not affect actual performance or growth rates.

In conclusion, mastering the art of analyzing a Profit and Loss Statement is a crucial skill for investors, analysts, and business owners. This financial document serves as a compass, guiding us through the journey of a company's financial performance. By delving into the intricacies of revenue, expenses, and profit, we wrap the story behind the numbers, gaining insights that drive informed decision-making.

Thank you for joining me on this journey of financial exploration. Here's to your financial literacy and the prosperity it brings. If you have any further questions or topics you'd like us to explore, feel free to reach out. Happy analyzing!