Curious investors have a lot to consider before taking the plunge and buying a stock. One such consideration is a company’s financial standing. Luckily, there are several key documents that are made publicly available for anyone who wants a glimpse into a company’s financial operations.
Investors may be particularly interested in a company’s profit and loss statement. A profit and loss statement reveals how much a company earned over a designated period, like a quarter or year. As the name suggests, the statement details both the revenue and expenses that led to either a profit or a loss.
At first, looking at financial statements can feel like reading another language. Investors who want to learn how to read a profit and loss statement will find it only gets easier with practice. Here’s how to get started.
What is a Profit and Loss Statement?
Ever heard someone ask, “what’s the bottom line, here?” Though this adage is now used euphemistically to inquire about only the most important details of any matter—financial or not—the phrase is borrowed from the literal “bottom line” of a profit and loss statement.
When running a business, profitability is the ultimate goal. A profit and loss statement shows how much revenue a company earned over a specific period, and then subtracts how much it spent, which results in a net profit figure. It’s the final line in the grand calculation.
A profit and loss statement is also called an “income statement.” Understandably so, as it presents both the income and expenses that ultimately created profitability—or loss—for the period.
The profit and loss statement is one of a business’s most important accounting tools. It’s also one of a handful of financial statements officially filed by public companies. 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). Investors can find this information by searching for the company within the SEC’s EDGAR database .
It can be useful to think of each of the accounting statements as individual pieces in an overall puzzle. For example, compare the profit and loss statement to a balance sheet, which details information about a company’s assets and liabilities. The balance sheet alone may not 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.
How to Read a Profit and Loss Statement
Profit and loss statements are a particularly useful tool for looking into the operations of a company. They are perhaps most useful when used to compare two or more different periods, or when comparing companies within the same industry. As with almost any accounting report, context can help to anchor the information. 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? Or, are there any additional clues as to the financial inner workings of the company?
For example, perhaps a company is profitable in one period and not the next, because of an increase in research and development (R&D) costs. This is valuable information to a potential investor. In fact, such a discovery may shift their line of questioning altogether. Instead of asking about the profitability of the company right now, they might focus on the value of this one-time R&D expenditure into the future.
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 revenue. This is how much money a company earned through sales. Next, costs are subtracted. And at the end, 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 may actually be 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. 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.
Profit and Loss Statement Overview
There are other relevant line items an investor might encounter on a profit and loss statement. To recap, one would find the total revenue at the top. This number is also called gross sales. (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.
The result is net revenues, which is likely the next line in the statement. (Net refers to a figure after the necessary deductions are made.) This is a more accurate picture of what incoming cash flow looks like.
Moving down the statement, expenses come next. Although there is no required order, it is common to list the cost of sales as the first expense. This is the amount of money that the company spent to produce the 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.
Next, there may be a line titled gross profit or gross margin. This indicates the profit made on the goods sold before operating expenses. (“Gross” indicates that there are still expenses to consider.)
Operating expenses come next. They are the general costs of running a business, such as maintaining payroll, office buildings, and marketing and research fees. Here, depreciation may also make an appearance as a line item. Depreciation is defined as the reduction in the value of an asset with the passage of time, due in particular to wear and tear. Businesses are able to treat this depreciation as an expense.
Once all operating expenses are subtracted, the result is operating profit, or “income from operations.” This figure represents the income before interest and tax expenses are accounted for. That comes next.
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.
Finally, income tax is deducted. Typically, this is the last deduction before the final line in the statement: 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?
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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