A profit and loss statement (P&L) reveals how much a company earned over a designated period, like a quarter or year. A profit and loss statement is also called an “income statement,” as it presents the revenue and expenses that ultimately created profitability — or loss — for the period.
The P&L report is one of a business’s most important accounting tools, as it provides important insights into business operations. Investors can also use the P&L to assess certain aspects of company performance and compare it to other companies in the same industry.
If you want to learn how to read a profit and loss statement, here are some key points to know.
What Is a Profit and Loss Statement?
Ever heard someone ask, “What’s the bottom line, here?” That phrase comes from the literal “bottom line” of a P&L statement.
A profit and loss report shows how much revenue a company earned over a specific period, and then subtracts how much money was spent, which results in a net profit (or loss). It’s the final line in the grand calculation.
In addition to filing a P&L report, companies will also file a balance sheet, cash flow statement, and statement of shareholders’ equity. Filings are made quarterly (called 10-Q filings) and annually (10-K filings) with the Securities and Exchange Commission (SEC), and are publicly available. Investors can find this information by searching for the company within the SEC’s EDGAR database.
Companies are complex, and although having a basic overview of how to read a profit and loss statement can be helpful, it’s important to bear in mind that different companies and industries may include breakout different line items in their P&L report.
Generally speaking, it’s useful to think of each of the accounting statements as individual pieces in an overall puzzle. For example, compare a company’s P&L to its balance sheet, which is a snapshot of a company’s assets and liabilities for a specific date. The balance sheet alone won’t indicate whether the company is operating at a profit, and a profit and loss statement may not provide an accurate picture into a company’s indebtedness. But together, both statements provide important context for further analysis.
What Is a P&L Statement Used For?
Profit and loss statements are a particularly useful tool for looking into the operations of a company and identifying important trends in that business, often providing insights into where (and maybe why) a company is making or losing money. For example:
• Where is most of the money being spent?
• Are there expenses that could be trimmed?
• Are gross sales covering the cost of production?
The P&L report is also useful when used to compare two or more time periods, or when comparing companies within the same industry.
As with almost any accounting report, the P&L can spark important questions. What changed from last year (or last quarter)? What has improved? What has not? In particular, has the company been able to decrease expenses or increase revenue in order to secure more profit?
Most important, the P&L report may provide additional clues as to the financial inner workings of the company. It can help identify problem areas as well as growth opportunities.
For example: Perhaps a company is profitable in one period but not the next, because of an increase in research and development (R&D) costs. This is valuable information, as it may indicate a crucial investment for a new product — which can lead to an evaluation of this investment.
Is this a wise use of capital, and will it pay off in terms of a new product’s success? Could the money be better spent elsewhere, or is there a more efficient way to develop the new product line?
How to Read a P&L
When learning how to read a profit and loss statement, investors should know that they generally follow a similar format.
Each begins, at the top of the page, with total revenue. This is how much money a company earned through sales. Next, costs and expenses are subtracted. Finally, at the bottom of the page, is the company’s bottom line: profit or loss.
Although a company’s “top line” revenue is a compelling figure, a company’s bottom line is typically a better indicator of whether it will be an enduring, successful business.
To illustrate the point, consider a simple example of two companies. The first company posted revenue of $10,000,000 last year, but incurred the same amount in expenses (– $10,000,000). They had high revenue, but earned no profit.
The second business earned $1,000,000, but incurred just $100,000 in expenses — resulting in a $900,000 profit. The second company brought in less revenue, but was more profitable than the first.
Understanding Each Section of the P&L
To really make sense of a P&L, though, you need to understand what each line item stands for and its relevance to the company’s overall operations.
Revenue (or sales)
To recap, one would find the total revenue at the top. This number is also called gross sales and it’s usually broken out by source. (A gross figure is one calculated before expenses are taken out.)
On certain sales, a company may ultimately receive a modified amount. For example, items that are returned or are discounted must be accounted for. Therefore, the next line in the statement may include a figure that represents what a company does not expect to collect on overall sales, i.e. net revenue. (Net refers to a figure after the necessary deductions are made.) This is a more accurate picture of what incoming cash flow looks like.
Cost of Goods Sold (COGS)
Moving down the statement, direct costs or cost of goods sold usually comes next. This is what the company spent directly on the production of goods or services that were sold during that period. For example, if a company produces shoes, it would include money spent on supplies, labor, packaging, and shipping (but not rent, for example, as that’s not a direct cost).
After COGS is subtracted from revenue, there may be a line titled gross profit or gross margin. This indicates the profit made on the goods sold before operating expenses.
Operating expenses include everything the company spent money on to stay in business: from IT to sales and marketing expenses to facilities costs and so on. These categories are often broken out into subcategories for specific expenses within each (for example, employee expenses might include payroll and benefits).
Total operating expenses are deducted from gross profit to get net operating income.
Net Operating Income
Net operating income, also known as EBITDA (earnings before interest, taxes, depreciation, and amortization are taken out), is a crucial part of the income statement. It reveals how much the company has after all the expenses are covered. If the number is positive, the company is able to cover the cost of doing business; if it’s negative, it means the company is operating at a loss. While that’s not uncommon, spending more than you earn is typically a red flag calling for some adjustments.
Interest Income and Expense
Interest income is money earned in interest-bearing bank accounts or other investment vehicles. Interest expense is the cost of borrowing money and paying a rate of interest on that debt. These numbers may or may not be combined into one figure.
Depreciation and Amortization
Depreciation is defined as the reduction in the value of an asset with the passage of time, due in particular to wear and tear (e.g. the depreciating value of computer systems or vehicles). Businesses are able to treat this depreciation as an expense.
Amortization is the distribution of a business expense over time (e.g. the ongoing cost of a certain software program over a few years).
Finally, any tax the company paid is also deducted. Typically, this is the last deduction before the final line in the statement: the net profit or the bottom line.
The bottom line represents the net profit or the net loss, and answers the question: During this accounting period, was this company able to turn a profit, or did they operate at a loss?
Note that profit is just one way to evaluate company performance — and it’s not the same as cash on hand. To understand how much actual cash a company has in the bank, you have to read the cash-flow statement.
Earnings Per Share
A profit and loss statement may also include an earnings per share (EPS) calculation. This is a representation of how much money each shareholder would receive if all net profit was paid out. EPS is calculated by dividing the total net profit by the number of shares a company has outstanding.
The EPS is a hypothetical calculation used by investors to assess the amount of profit created by a company. Do companies actually distribute total earnings? Not generally. Companies will typically keep some or all profits, and may make some payments to shareholders in the form of dividend payments. (The profit and loss statement may also include information on dividend payments.)
A large or a growing EPS is generally preferable but yet again, this metric alone is not sufficient in deciding whether a stock is a good investment. EPS should also be compared to the price of that stock. A company could boast a robust EPS, for example, but if the cost of the stock is relatively expensive, it might not be a good value. For a deeper look into the correlation between earnings and price, investors can consider the price-to-earnings (P/E) ratio, which divides the price of a stock by the EPS.
A profit and loss statement can give an investor a look at a company’s bottom line in terms of earnings — and also allows them to compare statements from companies in the same industry, as well as statements from the same company over different time periods. Learning how to read a profit and loss statement can be an important part of researching a company in which one might want to invest.
While a profit and loss statement provides contextual insight into a company’s financials, these figures only tell us what has happened in the past, and not what will happen in the future. Given that, this information alone is not able to determine which is the “better” investment, but it is one of the many pieces of information needed to value a stock.
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