Understanding and reading Profit & Loss Statements

research and draft compiled by Subhadra Kartik

article written by Wayne Brown

Getting started with the terms…

…extract from two articles

As a business owner, you must track the money going in and out of your company to keep your finances on track. You probably already have a number of responsibilities on your to-do list. Depending on your situation, you may have to manage taxes, monitor your business credit and finances, and perhaps even oversee daily sales or operations.

It’s understandable that you might feel worried about adding more duties to the ever-growing pile. But once you get used to filling out your income statement template, you’ll get faster at the process over time. Your accounting software may help you complete this task as well.

By creating regular profit and loss statements, you can track your company’s financial health over time. This knowledge can provide you with opportunities to either double down on smart business strategies that are working for you or make course corrections when needed. But on top of that, a P&L can be used to help you make informed decisions like:

  • Can you afford to hire any new employees?
  • Can you afford to move to a bigger office?
  • How will you plan your taxes?
  • Is your current growth strategy effective?

If you make a profit, great! You can re-invest it, save it, or make a variety of other decisions. If you end up with a loss, it’s a clear signal that your business is on an unsustainable trajectory, and you’ll need to find a way to turn things around.

Even if you’re comfortable creating your own financial reports, a professional accountant can save you time and free you up to focus on other areas of your business. There are actually four different terms used to describe the report that helps you calculate your company’s net income — profit and loss statement, P&L statement, statement of revenue, and income statement.

What Is a Profit and Loss Statement (P&L)

…additional to the above sources, this section includes extracts from Freshbooks Cloud Accounting

The profit and loss ((P&L) report is a financial statement that summarizes the total income and total expenses of a business in a specific period of time. It is also known as the income statement or the statement of operations. The goal of a P&L report is to measure the profits by excluding the expenses from the income and provide an overview of the financial health of the business.

The P&L statement is one of the three most important financial statements for business owners, along with the balance sheet and the cash flow statement (or statement of cash flows).One of the most common reasons small businesses start producing profit and loss statements is to show banks and investors how profitable their business is.

When profit and loss statements are meant to be shared outside a business, they’re called income statements. A P&L statement is for internal use only. Other than that, the two statements are essentially the same.

If you have a bookkeeper or accountant, they may already generate P&L/income statements for you. Likewise, many types of accounting software will automatically generate useable income statements, so long as you accurately categorize all your transactions.

Based on the standard operating procedure of a business, these statements are generated on a weekly, monthly, quarterly or annual basis.

The basic formula of a P&L report is: Revenue – Expenses = Profits

Pro Forma P&L

  • The first time your business should create a P&L statement is right at the beginning. You probably won’t have any actual income or expenses to report at that point. Still, you can create a pro forma P&L to project these figures for the future. Pro forma income statements may be helpful when you apply for business loans or other types of financing. 

Periodic P&L

  • All established businesses should prepare a P&L statement from time to time. Ideally, your company should create a new report at least once a quarter. Monthly income statements are even better.
  • A periodic P&L statement can help you manage your business finances. You can compare your current statement to previous ones and see if your net income is improving or declining. A P&L statement can also help you when it’s time to prepare your business tax return.

How to Prepare an Income Statement?

…extract from FreshBooks Cloud Accounting

To prepare an income statement, small businesses need to analyze and report their revenues, expenses, and the resulting profits or losses, for a specific reporting period. To prepare an income statement to generate a trial balance report, calculate your revenue, determine the cost of goods sold, calculate the gross margin, including operating expenses, calculate your income, include income taxes, calculate net income and lastly finalize your income statement with business details and the reporting period.

To write an income statement and report the profits your small business is generating, follow these accounting steps:

  • Reporting Period – The first step in preparing an income statement is to choose the reporting period your report will cover. Businesses typically choose to report their income statement on an annual, quarterly or monthly basis. Publicly traded companies are required to prepare financial statements on a quarterly and annual basis, but small businesses aren’t as heavily regulated in their reporting. Creating monthly income statements can help you identify trends in your profits and expenditures over time. That information can help you make business decisions to make your company more efficient and profitable.
  • Generate Trial Balance Report – To create an income statement for your business, you’ll need to print out a standard trial balance report. Trial balance reports are internal documents that list the end balance of each account in the general ledger for a specific reporting period. It will give you all the end balance figures you need to create an income statement. You can easily generate the trial balance through your cloud-based accounting software
  •  Calculate your Revenue – Next, you’ll need to calculate your business’s total sales revenue for the reporting period. Your revenue includes all the money earned for your services during the reporting period, even if you haven’t yet received all the payments. Add up all the revenue line items from your trial balance report and enter the total amount in the revenue line item of your income statement.
  •  Determine Cost of Goods Sold – Your cost of goods sold includes the direct labor, materials and overhead expenses you’ve incurred to provide your goods or services. Add up all the cost of goods sold line items on your trial balance report and list the total cost of goods sold on the income statement, directly below the revenue line item.
  • Calculate Gross Margin – Subtract the cost of goods sold total from the revenue total on your income statement. This calculation will give you the gross margin, or the gross amount earned from the sale of your goods and services.
  • Include Operating Expenses – Add up all the operating expenses listed on your trial balance report. Enter the total amount into the income statement as the selling and administrative expenses line item. It’s located directly below the gross margin line.
  • Operating income – Subtract the selling and administrative expenses total from the gross margin. This will give you the pre-tax income. Enter the amount at the bottom of the income statement.
  •  Include Income Taxes – To calculate income tax, multiply your applicable state tax rate by your pre-tax income figure. Add this to the income statement, below the pre-tax income figure.
  • Calculate Net Income – To determine your business’s net income, subtract the income tax from the pre-tax income figure. Enter the figure into the final line item of your income statement.
  • Finalize the Income Statement – To finalize your income statement, add a header to the report identifying it as an income statement. Add your business details and the reporting period covered by the income statement.

Example Template Income Statement

The XYZ Inc. (P/L Statement year ended 31, Dec 2019)

CategoryAmount ($)Amount ($)
Sales 50,00,000.00
Cost of Goods Sold8,00,000.00 
Labor11,00.000.00 
Overhead6,00,000.0025,00,000.00
Gross Margin 25,00,000.00
Operating Expenses  
Selling Expenses9,00,000.00 
Administrative Expenses6,00,000.00 
Depreciation and Amortization5,00,000.0020,00,000.00
Operating Income 5,00,000.00
Other Income and expenses  
Interest Revenue    50000.00 
Interest Expense-1,00,000.00 
Extraordinary items2,00,000.001,50,000.00
Income Before tax 6,50,000.00
Income tax (35%) 2,27,500.00
Net Income 4,22,500.00

Who uses Income statements?

…extract from 4 sources

Profit and loss statements are invaluable to those who manage the company’s profit and loss. That person could be the CFO, the accountant, or the small-business owner themselves. However, other groups also look at income statements. Large public companies are required to release them, and banks and other financial institutions often require them before signing off on a loan.

Internal Uses – The income statement is used internally and externally. Internally, managers evaluate all financial statements to assess any changes. If gross margin declines, for instance, company leaders may look to negotiate better costs with suppliers or to use marketing to attract more buying interest. If operating expenses are high, you might have to negotiate with building owners, utility contractors and other providers. You may also look for ways to get more efficient use out of space and equipment.

External Use – External stakeholders may also want to see your financial statements. If you become a publicly traded company, you have to provide quarterly income statements for shareholders and analysts to review. If you look to private investors or creditors, they also want to review the income statement and other financial statements when conducting due diligence. Near-term and historic income usually plays a significant role in whether an investor or creditor decides to put money into your business.

  • Investors Investors will look at your P&L statements from multiple time periods to see how profitable your business is over time. They can also glean information about the efficiency of your operations, your competitiveness, and the soundness of your business model.
  • Lenders Lenders will look at P&L statements to determine whether or not your business is likely to make a profit in the future big enough to pay back loans and interest.
  • Shareholders If you are a shareholder, you need to know that the company is making enough profit in order to reward you for the risks that you have taken by investing. If not, the value of your shares will decrease.

Read and Understand Your Income Statement

…extract from 3 sources

All P&Ls are based on a very simple formula — sales minus costs equals’ profit. It really is that simple. Everything else is a matter of breaking out sales or cost into more detail and adding subtotals. Sales are typically shown at the top of the P&L. Costs are shown below sales and profit is at the bottom. You may see a number of subtotals as you look down the column, but it is still sales minus costs equal profit.

Unfortunately, we sometimes use different words for sales, costs and profits. This can make accounting seem more difficult than it really is. For example, sales can also be called revenue or income. Costs may be called expenses and profits may be referred to as net income. In fact, the P&L itself can also be called an income statement.

Top Line – Companies have to generate money to survive and grow. In other words, the money received from sales of goods and services is income. This revenue is also referred to as the “top line”. Then, subtract the expenses from this top line. The money paid out such as rent, electricity, salaries to employees, legal fees, repairs, advertisement, and bank charges are your expenses.

Of course, revenue is a pretty critical number as it’s what you need to cover your expenses. The lower your revenue number, the lower your expenses need to be in order to stay profitable.

Bottom Line – Costs like write-offs in the form of depreciation and amortization of various assets as well as taxes paid to the government are also taken out from the revenue. The result is called net income or the “bottom line”.

Direct costs – are also known as cost of goods sold (COGS). These are the costs that you incur when you make your products or deliver your services. You don’t include things like rent or payroll here, but you would include the things that directly contribute to each sale.

For example, for a bike shop, the direct cost of every sale is what the shop paid to buy the bikes from the manufacturer. For a bike manufacturer, direct costs would include the cost of the metal and plastic used to make the bike.

Gross margin – Subtract your direct costs from your revenue and you have your gross margin.

  • Revenue – Direct Costs = Gross Margin

Gross margin tells you how much money you have leftover to cover your expenses after you’ve covered the cost of the product or service you are selling. For example, if you buy a widget for $1 and sell it for $3, your gross margin would be $2. When you have a high gross margin that means that it costs you very little to deliver your product or service and you’ll have the majority of the money from every sale left over to cover your expenses.

Operating expenses – Operating expenses cover all of the expenses that you incur to keep your doors open, excluding your direct costs that we talked about earlier.

  • Expenses – Direct Costs = Operating Expenses

This usually includes your rent, salaries and benefits, marketing expenses, research and development expenses, utilities, and so on. Don’t include interest you pay on loans or taxes here, though.

Operating income – Operating income is also known as EBITDA (earnings before interest, taxes, depreciation, and amortization). This is calculated by subtracting total operating expenses from your gross margin.

  • Gross Margin – Total Operating Expenses = Operating Income

Interest – Here’s where you’ll include interest payments that your company is making on any loans that your company has.

Depreciation and amortization – These are special expenses associated with assets that your company owns. Over time, assets (like vehicles and large pieces of equipment) lose their value or depreciate. You’ll expense that decline in value here.

Taxes – Any taxes that you pay or expect to pay on your sales show up here.

Net profit – Also known as net income or net earnings, is the “bottom line” that you hear about so much. You started with your revenue as your “top line” and then subtracted things as you went: direct costs, operating expenses, and so on. What’s left over is your profit, or potentially your loss if you ended up spending more than you earned.

The Profit & Loss statement is a scientific reflection of the company’s financial health. Managers, creditors, and/or bankers should all use P&L Statements. It will help you estimate the company’s ability to generate cash flow. This report should be able to assist you in forecasting the likely future performance of the company to a fair degree.

Case Study – How to analyze an income statement – Walmart example

Introduction to the income statement. This income statement tutorial shows you how to get started with reviewing the income statement of a company. Walmart’s (NYSE: WMT) income statement, or profit and loss statement (P&L) for the fiscal years ended January 31st, 2017, 2016 and 2015. 2017. As retail is traditionally a fairly low margin industry, every penny counts. Net Income is almost 9 billion dollars lower than Operating Income, let’s review what is going on in the interest and tax lines.

Link: https://www.youtube.com/watch?v=jovKWaUxdmU

Case Study – How to read an income statement: Alphabet Inc case study.

The income statement of Alphabet Inc, the parent company of Google and other bets. Going down the income statement from top to bottom. The first thing that jumps out is the revenue of more than $110 billion. Second item: margins, how do operating income, and net income compare to revenue. The third item is an unusual one: The European Commission’s fine of $2.7 billion. The fourth item, other income which in the case of Alphabet Inc is a positive contributor. Fifth item: the provision for corporate income taxes. This looks unusually high at more than half of the earnings before taxes. “To Do” list for the Alphabet Inc income statement analysis: revenue, margins, European Commission fine, other income, and taxes.

Link: https://www.youtube.com/watch?v=ToE-oggQiqQ

Case Study – Reading Financial Statements- Amazon Case Study

Some financial statements examples from Amazon.com, Inc. for a more in-depth look at the accounts and line items presented on financial statements. The three core financial statements are the income statement, balance sheet, and cash flow statement.

Link:https://corporatefinanceinstitute.com/resources/knowledge/accounting/financial-statements-example-amazon-case-study/

Additional references

  1. Videos

101 Income Statement Introduction – Dec 2016

How to Prepare an Income Statement Accounting Accounting Principles – Dec 2014

What an Income Statement REALLY tells us – Case Study + Tutorial – Analyzing the income statement to determine London Coffee Company’s financial health using profitability margins and ratios. We interpret how these ratios change over time and their link to company strategy. March 2015

Understanding Profit & Loss Statement: Income, Cost of Goods – March 2018: In this QuickBooks Online tutorial you’ll learn what a profit & loss statement is along with:

  • Understand the Profit & Loss Statement and what it says about your business
  • Discover what Income, Cost of Goods Sold and Expense accounts are
  • Learn about accounting formulas that explain more about your business

Reading Income Statements – made VERY simple – March 2015 – Case study business, London Coffee Company to explain how an income statement works. We break down its line items into sales, expenses, and profits.

2. Books

Financial Statements, Third Edition: A Step-by-Step Guide to Understanding and Creating Financial Reports – Author: Thomas Ittelson, Published: April 2020

Financial Statements [Paperback] – Author: Thomas R. Ittelson, Published:NA

The Basics of Understanding Financial Statements: Learn How to Read Financial Statements by Understanding the Balance Sheet, the Income Statement, and the Cash Flow Statement – Author:  Mariusz Skonieczny, Published: June 2012

A Handbook on How to Use Your Financial Statements to Manage Your Business: Understanding Your Financials: The Number One Determinant of Small Business Success – Author: Jim Schell, Published: August 2017

Category: Finance 4 Execs

This was the second article in the initial Finance series. Exploring the topic of the Profit and Loss Statement – otherwise known as the Income Statement.

NEXT UP: WHAT IS EQUITY AND WHY DOES IT MATTER

Until then, stay safe and healthy. Bye for now. Wayne