Farwah Jafri | May 16 2021
The P&L (Profit and Loss) statement is a financial statement/tool that displays the revenue earned and expenses incurred by a business in a specific period. It is often referred to as an Income Statement, as it also shows the profits generated by the business. Understanding how to read a P&L statement thoroughly allows companies to plan and devise profitable strategies for the future.
A P&L statement is also one of the major three financial reports that a public company has to openly publish and show to the shareholders – the other two reports being the Balance Sheet, and the Cash Flow Statement. These records dictate the current financial position as well as predicted future growth for any business. Before learning how to read a P&L (profit and loss) statement, let’s first compare it with its counterparts to know the difference between them clearly.
The P&L statement and balance sheet are amongst the two primary financial records of every organization. Both of these statements contain crucial information regarding the financial health of a business and how it’s performing in the industry. The balance sheet includes assets and liabilities that show the worth of the organization, and the P&L statement includes revenues and expenses that show the net income of the organization. Whereas the balance sheet is more focused on the ownership of the business and its long-term prospects, the P&L statement is focused entirely on one primal point: the profitability of the business.
See Also: How to Read and Understand the Balance Sheet
As per its name, the cash flow statement highlights the in-and-out flow of cash of a business. Many transactions are noted in the cash flow statement but not in the P&L statement, including the purchases of new assets and investment securities. A P&L Statement focuses more on the realized profits or losses for a business, whereas the cash flow statement displays the exact current cash holdings. Nevertheless, it is vital that you know how to read your P&L statement and your cash flow statement before making any future payments or purchases for your business.
A P&L statement includes all the components that help to run the business effectively on a daily basis and surprisingly, it is not very complicated to understand. If you analyze it section-wise, you can quickly identify the importance of every individual component. So, let’s dive deep and learn how to read a P&L statement.
The P&L statement is divided into the following six major sections:
The first step of understanding a P&L statement is through the income and revenue section, which dictates the money earned by a business through sales of products/services. It includes both the income earned, the direct cost of services, as well as the gross profit. Different sources of revenue are listed separately for clarification, such as tangibles, non-tangibles, etc.
The direct cost, also known as Cost of Goods Sold (COGS), is the cost undertaken to manufacture the products and manage the services. These costs are paid by the organization and are important to be noted. COGS also include direct material and labor expenses that are required for the manufacturing of each product or service that is sold.
The Gross Profit is simply the Total Revenue minus Direct Costs (Revenue – COGS). It shows the gross income earned by the organization for the products and services for a particular period.
Understanding expenses is one of the most significant aspects of reading a P&L statement. Every organization has operating expenses; money required on a day-to-day basis. These expenses are divided into several categories and sub-categories, depending upon the nature of your organization. Such expenses can sometimes mean cash directly out of the pocket; therefore, it is crucial that you note them. Some examples of these expenses include:
• Administrative costs
• IT costs
• Maintenance costs
• Employee payroll and benefits
• Sales and marketing expenses
• Facilities/storage cost
• Research and development cost
There are also other miscellaneous expenses that are not included in the expenses section. These include:
Taxes: includes all the money you have paid or are expected to pay to a government body.
Depreciation: the decline in the value of a tangible asset over time. This decrease in value is noted in monetary terms.
Amortization: similar to depreciation but for intangible assets.
Interest: payments made on any outstanding loans taken by your company.
Net Operating Income is a very significant step in reading the P&L Statement. It is calculated by subtracting operating expenses from the gross profit (Gross Profit – Operating Expenses). It is also known as EBITDA (Earnings before Interest, Taxes, Depreciation, and Amortization). The net operating income indicates whether the business is heading towards profit or loss. If the calculated amount is positive, then the business is handling the revenues well and is running on profits. If the calculated amount is negative, then there is a need for substantial shake-ups as the business is heading towards a loss.
Understanding Net Profit is the final step of reading a P&L statement. Net profit is the prime figure that dictates the profitability of your business after all the other expenses are incurred. It is calculated by subtracting the other expenses from the Net Operating Income (Net Operating – Interest, Taxes, Depreciation, Amortization). The amount that remains after calculating all the expenses is the true profitability of a business. It can either be shown as a positive number (profit) or a negative number (losses).
Although it is quite simple, if you are having any sort of problems in understanding how to read a P&L statement, then you should focus generally on the Net Profit, as it is ultimately the main number to be noted. It dictates the profit-position as well as helps you to understand the financial potential of your business.
See: 9 Reasons Business Owners Should Consider Outsourcing Accounting
Farwah is the Product Owner of Monily. She has an MBA from Alliance Manchester Business School, UK. She is passionate about helping businesses overcome challenges that hamper their growth, which is why she is working at Monily to facilitate entrepreneurs to efficiently manage business finances and stay focused on growth.