How to study a Profit and Loss Statement?

[This article elucidates methods and techniques used in the  analysis of profit and loss statements, the Format of the operative statement, the meaning of gross profit, operating profit and net profit, depreciation, amortization, etc.]

The profit and loss (P&L) statements are one of three financial statements that every public company issues quarterly and annually, along with the balance sheet and the cash flow statement. When used together, the P&L statement, balance sheet, and cash flow statement provide an in-depth look at a company’s overall health. The P&L statement allows banks to appraise the total income, debt load, and financial stability of the business. Therefore, it is one of the primary documents the borrower needs to provide when applying for a loan or other types of funding.

The detailed financial statement which summarises all the income/revenue and all the expenses on earning of revenues is called a ‘Profit & Loss statement’ or ‘Income Statement’ or Income Summary. The profit or loss, brought about by operations during the period of two balance sheets and retained profit thereon, is responsible for an increase or decrease in the owner’s equity in the business. Naturally, all the stakeholders of a business including the lenders are interested in the analysis of profit and loss statements. Gross Profit, Operating Profit, Net, Profit before Tax/Loss, Net Profit/Loss after tax, depreciation & Provision for expenses profit are the important components of Profit and Loss Accounts. The bankers along with other stakeholders- holders study the trends of all the above components and infer the performance of the company. By comparison of Profit & Loss statements corresponding to periods of previous years gives us fare idea of an increase or decrease in sales, increase or decrease in manufacturing cost, increase or decrease in overhead charges, financing charges, etc.

What is a profit and loss (P&L) statement?

Let us first understand what a P&L statement is. The profit & Loss statement is prepared in a T format. The contents of revenues earned are listed on the right-hand side of T and all the expense contents are listed on the left-hand side of T. The listing of contents is done in such a method that is fairly easy to summarise. The right-hand side is referred to as the credit (Cr.) side and the left-hand side is referred to as the ‘debit’ (Dr.) side. It is a common practice to present the revenue and expenses in the summarised format and the details are attached to schedules. However, the method of presentation of the profit and loss account does not alter the end result.

How did ‘Gross Profit, ‘Operating Profit’ and ‘Net profit’ arrive?
Gross profit, also known as gross margin, is obtained by subtracting the cost of sales from the sales revenue. In view of gross sales varying without any real increase or reduction in sales owing to variation in excise duty; bankers prefer to consider net sales, instead of gross sales.
Gross Profit=Net Sales-Cost of sales. (Net Sales= Gross Sales – Excise duty)
Cost of sales (COS) = (Cost of Production (COP) + Opening stock of finished goods-Closing stock of finished goods). [Note that the banker’s concept of cost of sales is different from the approach of cost accountancy. In cost accountancy, selling, and administrative expenses are also included in the cost of sales.]
( Cost of production/COP= Raw materials consumed+ manufacturing expenses+ Depreciation, + opening stock of work in process- closing stock of work in process.)
Operating Profit (before interest) is the figure obtained after deducting personnel expenses (remuneration and other benefits provided to staff and workmen) and other operating expenses from gross profit.
Operating Profit after interest is derived by deducting interest expense from the figures of operating profit.
Profit before Tax/Loss: The net of non-operating income and non-operating expenses is added to operating Profit to arrive at Profit before tax. Hence Profit before tax is the surplus after meeting all other expenses, including interest expenses, except provisions for Tax.
Net Profit/Loss after tax: The profit before tax determines the income tax payable on the profit earned. Therefore, Net Profit/Loss after tax is the net amount of surplus/loss after Tax provisions. The profit after tax is available to the owners either to distribute to shareholders as dividends or retained in the business to improve the owner’s equity. The net profit or profit after tax is an important indicator of a firm’s performance.
Depreciation expenses: Depreciation means writing off the value of an asset over a period of time due to wear and tear, age, and obsolesces. There are three major methods of charging depreciation or recognition of the cost of the expiration of the cost of fixed assets viz. ‘straight-line method’, ‘written down value method’ and ‘Sum of the year’s digit method”. These different methods of depreciation are applied to fixed assets based on the plan that how the cost should be treated as expiring over the life of the assets. Depreciation is a major issue in the calculation of a company’s cash flows, because it is included in the calculation of net income, but does not involve any cash flow. Since depreciation is a non-cash transaction, a cash flow analysis requires the inclusion of net income with an add-back for any depreciation recognised as expenses during the period.   Click here to  know  more about depreciation and amortization

Provision for expenses: Provision for expenses is the estimate of expenses relating to an accounting period, payable after the accounting period. Such future payments related to expenses of the accounting year are debited to the respective heads of expenses and credited to provisions for the expenses account which will be paid to the respective creditors in the subsequent accounting period by debiting provision for the expenses account. Provision for expenses for the amount payable in the subsequent accounting period, is a must, in order to make a reasonably accurate measurement of the profit or loss of the period. For example, the expenses like salaries, premises rent, electrical bills, telephone bills, audit fees, etc. related to the last month of the accounting period payable subsequent to the accounting period, are taken into account by showing them under Provisions. Similarly, if some of the accounts are under ‘Account receivables’ and the payment is not received, and if there is no chance of recovery, provision for bad debts is a must. Note: Provision for expenses is also an expense. Therefore not making any provision for such bad debts indicates over-stated receivables, and thereby shows inflated figures of profit.

Analysis of P&L statement:
Many methods and techniques are used in the analysis of financial statements including profit and loss accounts. They include (i).Trend analysis (Historical standard): A comparison is done of current performance with past figures of the firm. (ii). External Standards: Comparison is done between the two business concerns of the same size, which can also be made with ‘Industry average’. (iii). Goals/Corporate planning & Policies: Comparing the actual performance with the budgeted performance, to find out whether actual performance is good, to the set in goal in the prevailing circumstance). Comparison of Profit & Loss statements with the corresponding period of previous years gives us a fair idea of an increase or decrease in sales, increase or decrease in manufacturing cost, increase or decrease in overhead charges, financing charges, etc.

Format of the operating statement:
The various items in the Profit and Loss account are classified by putting them in a format ( Operating statement), as prescribed by RBI for credit monitoring arrangement. The format of the operating statement which can be easily read is appended below.

Originally posted on July 20, 2014, edited and reposted on March 27, 2023

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