When assessing a business’s profitability, analysts or investors can analyze Profit and Loss Statement besides combining with insights from other two important financial statements (Balance Sheet and Cash Flow Statement). This article shows what PnL is, examples and how to read PnL in the most effective way.
1. Profit & Loss Statement Definition
PnL Statement, also called Income Statement, summarizes a company’s financial performance by recording revenues, costs, expenses incurred in a specific period of time and net earning profits. This financial statement reflects past performance of a business and assesses capability to generate future cash flow.
Unlike private companies which are not necessarily required to have a formal PnL, public companies have to file their financial statements to the Securities and Exchange Commission (SEC).
1.1 Differences PnL and other two financial statements
While PnL shows the profitability of a company, Balance Sheet is a snapshot of what companies own or owe in a specific point in time and Cash Flow reveals a business’s cash movements.
Cash Flow Statement
A snapshot of a company’s financial position
A measure of the company’s operational performance
Reports on the company’s cash movements
A point in time
A period of time
A period of time
Assets, Liabilities, Equity
Revenue, Expense, Profitability
Increases and decreases in cash
Cash; Accounts Receivable; Inventory; Plants, Property & Equipment (PP&E); Accounts Payable; Accrued Expenses; Debt; Shareholders’ Equity.
Revenue; Cost of Goods Sold; SG&A (Selling, General & Administrative) Expenses; Operating Income; Pre-Tax Income; Net Income
Cash Flow from Operations; Cash Flow from Investing; Cash Flow from Financing
1.2 Components of PnL
Includes revenue nets the amount reported after taking into consideration returned goods and allowances for price reductions or discounts.
The excess of sales over costs of goods sold. It presents how well the firm’s core business is capable of making profit.
Operating Income (EBIT)
Determined by subtracting all operating expenses from the gross margin, operating income is revenue earned from its core operations.
A type of net income that doesn’t take interest and tax payments, and depreciations and amortizations into account. It’s basically the income of a firm after subtracting Costs of Goods Sold and Operating Expenses (without D&A).
Depreciation and amortization
Captures each year’s decline in value. Amortization reports the year’s decline in value of intangible assets; Depreciation reports the year’s decline in values of tangible assets.
Cost of Goods Sold
The costs a company incurs to purchase and convert raw materials into the finished products that it sells.
General and administrative expenses
Correspond to overhead expenses, salaries, advertising, and other costs of operating the firm that are not directly attributable to production
Interest expense on the firm’s debt
The interest expense paid on debt. It must be paid periodically whether or not the company is profitable.
Taxes on earnings owed to federal and local governments
Every company has an “effective tax rate” that is based on the level and nature of its income.
Non-operating Revenues and Expenses
Include gains from non-primary business activities such as investments, patent income, and gains from asset disposals. Non-primary expenses come from losses such as investments, borrowing interest, loss from asset disposals.
From investors’ point of view, the utmost importance in an Income Statement is Net Income calculated after subtracting the expenses from revenue. This metric enables them to estimate the profit for the year attributable to the shareholders.
A profit and loss statement enables professional financial analysts to make recommendations about financial health of a company and whether to invest or acquire that business. There are several factors to consider in a PnL:
- Rate of return: return on assets (ROA), return on equity (ROE)
- Comparing a business in its industry and trend
- Analyzing year-over-year performance
- Margin: EBITDA, operating margin, net profit margin, gross profit margin
- Valuation: EV/EBITDA, EPS, P/E Ratio, Price/Earning-to-Growth, etc.
1.3 Examples of PnL
The above example shows Apple’s profit of approximately $53 million in 2015, $45 million in 2016, $48 million in 2017. Below the line of operating revenue is always Cost of Revenue (also called Cost of Goods Sold, Cost of Sales) since the residue of Revenue and Cost of Revenue is Gross Profit, which is important for analysts to assess its capability of generating profits from its core competency.
Then comes Operating expenses (R&D, Selling and general and administrative), which leads to the Operating Income (also called EBIT – links to EBIT and EBITDA) after taking Gross Profit net Operating Expenses.
Beyond revenue and costs of its core business, Apple has gains and expenses for non-core business, which are mentioned in the section Other Revenue and Expenses. Here, Apple doesn’t present its other incomes and expenses completely in its Income Statement but taking the net of the two for the sake of simplicity. You will then see “Income before Provision for Income taxes”, which is the estimates calculated by Apple for its taxes it is likely to pay when the finalized number hasn’t been done. The final line item is Net Income (also called “the bottom line” of the income statement) presenting the income of the firm after all expenses have been net.
Note: The net income in the income statement is the “accounting” income that is different from the real cash inflow from its business. Instead, to see how much cash the firm has and how the cash flows through the firm’s operation, you should look at the Cash Flow Statement. (the Balance of cash and cash equivalents in the Balance Sheet also presents how much cash it has yet doesn’t show the movements)
2.1 There are 3 basic accounting principles for PnL Statement
Revenue recognition principle
This accrual principle enables your business to show profit and loss accurately by recording revenue when it is earned, without having to wait until the cash is collected.
For example, Morgan Stanley made a-billion M&A deal between Facebook and Instagram in July 2018 and the payment was in January 2019. Thus, Morgan Stanley had to record the revenue in July 2018 because the revenue was realized at that month, though it was not received until January 2019.
This principle dictates the company’s expenses correlated with the revenue at the same period of time.
For example, a salesman earns 10,000 USD in December 2020 with 8% commission but his payment is payable in January 2021 when his transaction is executed. Based on matching principle, the commission expense of the company is recognized in December 2020 same as revenue 10,000 USD recognize.
2.2 There are 2 Methods of Constructing an Income Statement
This approach gives a straightforward summary of income and expenses without breaking them into different categories like multi step.
This approach goes deeper in revenue and expenses such as non-operating revenue, gains, non-operating expenses and losses. It distinguishes the revenue and expenses that are directly related to business operations from those that do not adhere to operations.
Easy to understand and prepare
– Give an inside look of business health from detailed operations.
– Include gross profit which helps to evaluate how effectively a business uses labor and supplies to generate revenue.
– Record operating income which shows how the company earns profit from its primary operation.
Lacks details about the company’s operation.
Take time to prepare and difficult for new investors
– Suitable for small business with simple operation structure (sole-proprietorship or partnership)
– Internal purpose: single department’s performance review and planning. Sometimes, this method is combined with multi step but less detailed than actual multi step income statement.
– Small businesses are raising fund through bank loan or investors.
– Large business with multi business operations.
1. Operating revenue (generating from main business activities)
2. Non-operating income (generating from investments, for example)
3. Operating expenses
1. Operating revenue
2. Non-operating income
3. Operating expenses
4. Non-operating expenses
5. Gross Profit
Net Income = (Revenues + Gains) – (Expenses + Losses)
1. Gross Profit = Net Sales – Cost of Goods Sold
2. Operating Income = Gross Profit – Operating Expenses
3. Net Income = Operating Income + Non-operating items
Multi Step Income Statement Example
3.1 It does not provide a big picture behind the numbers: A PnL simply looks at how revenue is generated from activities without analysing some qualitative factors such as how the company earns from its customers, sales policy or practices to improve business’s reputation.
3.2 Regarding accounting rules, a PnL is reported with all revenue and expense recognition without reflecting cash changing hands.
3.3 There might be a room for data manipulation, because a PnL is prepared after all the financial data recorded in the business.
4.1 Analyzing the Balance Sheet
Working capital (current assets minus current liabilities) represents the amount of a company’s current assets that would be left if all current liabilities were paid. Companies that have a comfortable amount of working capital are more likely to meet short-term obligations, expand its operations, and take advantage of opportunities, and therefore are more likely to attract conservative investors. Changes in working capital is often analyzed with regard to changes in cash flows to have a correct picture of the company’s financial health. Year-to-year increases in working capital and cash flow are not necessarily a good thing. It may be the case that the firm is running up long-term debts they cannot pay off because the firm cannot generate enough cash flow. On the other hand, decreases in working capital and cash flow can be a positive thing if the firm invests in new assets to expand its operations, which generate earnings in the long run.
More information on working capital can be found here.
Current Ratio (current asset divided by current liabilities) is one metric to gauge the working capital. In general, a current ratio of 2:1 is considered adequate.
Debt to equity ratio (total liabilities over total equity) indicates whether a company is using debt responsibly. Industrial companies normally try to maintain a debt-to-equity ratio of less than 1:1—thereby keeping debt at a level below the owners’ investment level. Utilities, service companies and financial companies often operate with much higher ratios.
Inventory turnover (Cost of goods sold over average inventory for a year): the number of times goods are bought, manufactured, and sold out on an annual basis.
Net Book Value refers to the amount of corporate assets backing a company’s bonds or preferred shares. Net book value per share is the amount of money each shareholder would receive if they company were to liquidate.
Two ways of calculating net book value per share
4.2 Analyzing the Cash Flow Statement
Cash flows from financing activities include:
- Issuance of debt or equity securities
- Repayment of debt
- Distribution of dividends
Cash flows from investing activities include:
- Activities related to asset acquisition
- Activities related to asset disposal
Cash flows from operating activities include:
- Cash collected from customers
- Interest received and paid
- Dividends received
- Tax payments