14 Mar Making the Most Out of Your Profit and Loss Statement
Are you really earning an income? Does it mean that a higher revenue automatically translate to a profitable business? Is your operating income comparable to your competitor’s net income? Or are these two different concepts?
The purpose of the Profit and Loss Statement (or sometimes referred to as the Income Statement) is to summarize a business entity’s performance over a period of time. It allows entrepreneurs and other users to make important decisions by understanding important measures such as sales and profitability.
To help you gain an appreciation of this report, here are some details about the items found in your P&L Statement, as defined by the Financial Accounting Standards Board (FASB) Concept Statement No. 6 “Elements of Financial Statements.”
Elements of Income
What: Generally, income is the difference between resource inflows (Revenues and Gains) and outflows (Expenses and Losses) over a period of time.
So what?: If your P&L is presented in a “one-step” format, then the Revenues and Gains are grouped together, the Expenses and Losses are grouped together, and their resulting difference would then be the Net Income or Loss. If you are using the “two-step” format, then subtotals are presented to show different levels of profitability (such as Gross Margin and Operating Income) which makes it more useful for decision making purposes. You can choose the format that would add more value to your financial reporting and decision process. These elements are discussed below.
What: FASB defines Revenue as “inflows or other enhancements of assets of an entity or settlement of its liabilities (or a combination of both) from delivering or producing goods, rendering services, or other activities that constitute the entity’s ongoing major or central operations.” Generally, revenue should be recognized when it is realized or realizable and earned.
So what?: If you are in the business of selling goods, revenue means Net Sales (Sales to customers less any sales returns, allowances, or discounts). If your operations revolve around providing services, then you have your Service Revenue, which is usually recognized on the basis of proportional performance. Reporting a lot of top-line Revenue is good, but it doesn’t automatically mean that you are well-off, especially if you also have a lot of Expenses to cover.
What: Expenses are “outflows or other using up of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.”
Some expenses can be directly matched to related revenues, such as in the case of Cost of Goods sold, which is related to the Sales of goods for the period. Other expenses can be systematically and rationally allocated when they relate to the use of an asset which may benefit several periods, such as the depreciation of equipment. Some expenses may be incurred to indirectly help generate revenue and are used up and recognized immediately within the period that they are incurred, such as administrative costs.
So what?: You can choose to present your expenses by function (Cost of Sales, Selling Expense, Administrative Expense, etc.) or by nature (Payroll Expense, Rent Expense, Advertising Expense, etc.). If you choose the former, you can present subtotals such as Gross Margin, which could be more meaningful for analysis. In any case, it is important to properly recognize expenses within the correct period to avoid misstatements of expenses and income taxes.
Gains and Losses
What: Gains are “increases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from revenues or investments by owners.” On the other hand, losses are “decreases in equity (net assets) from peripheral or incidental transactions of an entity and from all other transactions and other events and circumstances affecting the entity except those that result from expenses or distributions to owners.”
So What?: Gains and Losses arise from activities outside the ongoing major or central operations of your business. So if your business is not primarily about selling equipment (you sell pastries, for example), but you happened to dispose of fully depreciated company equipment, where the amount recovered from the sale was greater than the equipment’s residual value, then you have a recorded Gain that is totally different from your main Sales Revenue.
Subtotals in the P&L Statement
Below are common subtotals used in the P&L Statement and the related business insights they provide:
What: Gross Profit = Revenue – Cost of Goods Sold
So what?: The Cost of Goods Sold are costs that are directly related to creating the products or services sold during the period and is usually the most significant Expense on the P&L Statement. Therefore, by computing for Gross Profit, you would know the difference between how much it cost for you to make your product, and how much you were able to sell it for. After all, if you are not generating enough from your Sales to cover the costs directly associated with making your product or service, then you might not be able to stay in business for very long. You can also compute for your Gross Profit % (Gross Profit / Revenue from Net Sales) to make a comparable analysis with your prior period performance.
What: Operating Income = Gross Profit – Operating Expenses
So what?: Operating Expenses are usually comprised of Selling, General, and Administrative expenses such as office salaries, advertising, depreciation, rent expense, bad debt expense, etc. (generally, all expenses except Interest Expense and Income Tax Expense). Computing for Operating Income (also known as Earnings Before Interest and Taxes) tells you how your fundamental business operation is doing, outside of any financing and income tax effects.
What: Income from Continuing Operations = Operating Income + Other Revenue and Gains – Other Expense and Losses – Interest Expense – Income Tax Expense
So what?: This figure reflects your company’s overall economic performance and profitability that are expected to continue into the future. Assuming there are no irregular items (discontinued operations, extraordinary items, etc.), then Net Income would be the same as Income from Continuing Operations. If you want to compare this period’s performance with your prior year or with your competitor, you can compute for the Return on Sales (Net Income / Net Sales). This provides the Net Income percentage per dollar of sales and shows how efficient you were in actually generating profits from your revenue.
Your Profit and Loss Statements can be used to determine historical trends, as well as forecast future performance. You can do this by identifying which underlying factors affect the levels of your Revenue or your Expense. Most forecasting activities begin with the sales forecast, which indicates your expected growth and affects the levels of other activities needed to attain it. For example, the level of forecasted Sales impacts the expected level of Cost of Goods Sold, as well as the level of operating expenses that have a direct relationship to it. On the other hand, the level of Interest Expense depends on the level of interest-bearing loans you have. So if you expect your bank loans to increase, then you can forecast accordingly. Once you have identified these key factors, then you can make several assumptions or scenarios (best-case, worst-case) to aid you in evaluating your business alternatives moving forward.