2. The Profit and Loss Statement: The overview of performed minus consumed
3. Purpose of the Profit and Loss Statement
4. Structure of the Profit and Loss Statement
5. Perspective of the Profit and Loss Statement
6. Main terms of the Profit and Loss Statement
Revenue Cost Fixed and Variable Costs Direct and Indirect Cost Depreciation Contribution Margin and Gross Margin Operating Profit and EBIT Net Profit
The Profit and Loss Statement = Income Statement = Cost Benefit overview
The Profit and Loss Statement is the most widely used and most misinterpreted financial statement that exists.
Why? Because most non-financial people make no difference between "pay for" and "consume". In the world of finance, also called Financial Management, we make this distinction explicit because you do not need a filled bank account for one and you do need it for the other. In other words, for a financial person it is very important whether you talk about something that has to be paid (and for which sufficient resources must be available) or that you are talking about consuming something (which is a shame because it cannot be consumed again but for which no cash is needed.)
1. The three overviews of Financial Management
1.1 The Balance Sheet: The overview of assets and liabilities or in layman’s terms the overview of that what I have and to whom it belongs.
The Assets are represented on the left side, everything is written down what the company owns and what those items are worth in Euros. The Equity and Liabilities are represented on the right side and describe who has claims to the company to what extent. Read my detailed article about the Balance Sheet here.
1.2 The Cash Flow Statement: The overview of cash flows in and out of the company
The cash flow statement shows what money has flown into the company and has left the company in a certain period. We divide the Cash Flow into three groups (1) Operational: Cash Flow from the normal activities of the company, (2) Investment: cash outflows for investments or money inflow by selling assets selling previous investments, (3) Financing: Cash Flow to and from a loan provider or the owner. Read the entire article about the cash flow statement here.
2. The Profit and Loss Statement: An overview of the value from the performance minus that what is consumed to perform
The Profit and Loss Statement is based upon the activities of the company. What is the value of the company achievements aka the revenue or turnover, or in other words how many products times the price and or how many services times the price has the company delivered in the period. In order to assess whether this performance is "good" or "bad", we deduct everything the company has used to be able to perform, this is what we call the costs. If the revenues are higher as the costs we have a profit, otherwise a loss. Hence the name Profit and Loss Statement, the overview that shows what result we have achieved. Please keep in mind that the moment of Payment or Receival is NOT part of the P&L. For the P&L we allocate the costs to the revenues. This means that we only have the cost of the product at the moment we have the sale. This linking of Revenue and the Costs in the same period called Matching or Accrual Accounting.
Financial Management already exists from 1340. Before that date, we only had an overview of the money that came in and went out (The Cash Flow Statement). Although it is very important to know what happened at the bank account you have no inclination if it is "good" or “bad”.
To asses performance I want to make a comparison of that what I have achieved (turnover = number x price) minus what I have used (= costs). When I receive or pay the money, I do not consider the Profit and Loss Statement at all.
The goal of every "for profit" organization is, as the word implies, to achieve the highest possible profit. More specifically, to achieve the highest possible profit in relation to the capital that is used to realize this. See also the goal of the Balance for the link. Also the "not for profit" organization has the goal to maximize their goal within the available means. Therefore the assessment principles are often the same.
All Profit and Loss Statements all over the world are structured the same! Yes, even the English who do everything differently, drive to the left, count in miles and turn the balance upside down even they make the Profit and Loss Statement in the same way.
The first line from every Profit and Loss Statement is always the turnover, the value of the delivered products or services in the period.
Secondly we extract everything that is used for the delivered products and services from the revenue. Please note only the costs of the products sold are included. If not sold they are parked in the inventory on the Balance Sheet = the overview of that what we have.
The costs (= what we have consumed) are split into fixed groups.
Secondly we deduct costs from the turnover that have to do with the turnover but not exactly 1 on 1. You can think of logistical costs or selling costs.
Finally, the costs are deducted that have little or no relation to turnover and are often referred to as the Operating Expenses. Think of research and development, management, administration, housing or personnel affairs. Because there is no link to the revenue we usually take 1/12 every month.
The calculation of the subtotals in all Profit and Loss Statements are the same. Think of the Marginal Contribution or Gross Margin. To understand what a subtotal includes you only have te review all the costs above.
Unfortunately there is no one correct way to state what costs are included in a financial term.
Take for example a car:
- For a garage who sells cars daily it represents inventory and is part of the cost of goods sold;
- For a carpenter it is something he uses to perform the service and is part of the logistical costs;
- For an accountant it is part of the Operating Expenses.
Each company uses the same structure for the Profit and Loss Statement but the outcome is different. Each company determines itself which costs are most directly related to the turnover and are therefore high in the Profit and Loss Statement. For a Bank, for example, Interest is a basic activity and will therefore be high on the Bank's Profit and Loss Statement, while almost all companies have taken interest rates as last item on the P&L.
If you are going to buy a house you look at it from all perspectives, you walk around, go inside, preferably in the cellar and under the roof. When you manage a company, you also want to look at the company from multiple perspectives. How do I perform compared to last year or the budget, how do the various product groups react, how do the countries develop in relation to each other? Always with the aim to monitor the performance of the company and to take actions where needed.
The first line from each Profit and Loss Statement always represents the monetary value of the activity or services provided in the relevant period. We call this Sales, Turnover or Revenue.
Secondly we deduct what we have used to realize the turnover. We call these consumptions COST. Note: Products that we have produced but are not sold are stored in the warehouse and parked on the balance sheet. They therefore do not form part of the costs in the Profit and Loss Statement.
We divide costs into a number of groups. First of all, we make a distinction between FIXED and VARIABLE costs. Fixed costs remain the same even if I am going to produce or sell more or less. You can think of the costs of the land or building. Whether I produce more or less these costs do not change in the short term. Variable costs are linked to the activity and change with my production volume. So when I make more products, I also need more raw materials. Or if I have more sales, I have more logistics costs.
Of course, there are limits at fixed costs. I can make more products in my building, but if I want to double the production, this may no longer fit. In theory there are no fixed costs because if I want to do one million times as much it will never be possible within my current capacity.
In addition, we make a distinction between DIRECT and INDIRECT costs. Direct costs are linked to the sold product. If you sell a lot of products, you also have a lot of direct costs. Examples include materials and working hours of the products or services. Indirect costs are not strongly linked to sales. Think of accounting, personnel affairs or IT. You have these costs regardless of whether you have sold a lot or a little in the month.
A special type of cost is the depreciation. An example: Imagine buying a machine that I can use to make 100,000 seats after which this machine is worth nothing. To get that same machine working at my factory, I paid € 10,000 for the machine, transport and installation. Now I know that for every chair I'm going to make the machine is worth 10 cents less. I therefore have a depreciation of 10 cents per chair. The value of the machine on the balance is reduced by 10 cents for every machine I produce. The payment (= money outflow) of the machine plus transport and installation is included in the Cash Flow Statement upon payment at the beginning. Depreciation is a cost and represents the usage but has no payment aspect. If we continue with the example it becomes clear that I do have the 10 cents per seat as costs in my Profit and Loss Statement, however I have paid the full amount upon purchase which was included in the Cash Flow Statement. Depreciation therefore reduces my profit, depreciation does not reduce the cash flow.
In English we distinguish between depreciation (of material assets), amortisation (which is the same but related to immaterial assets) and impairment (which is an extraordinary correction, usually on goodwill, regarding the balance sheet value due to special circumstances).
To gain insight into the developments of parts of the Profit and Loss Statement we make use of subtotals. We give these subtotals a name like for example CONTRIBUTION MARGIN or GROSS MARGIN. Unfortunately, I have to disappoint you. There is not one correct formula to calculate the contribution margin or the gross margin. I can tell you what these terms mean to you in the company. Every Profit and Loss Statement is structured in a similar way. If you want to know what a subtotal means, do the following: Take the turnover and subtract all the costs above. This always works!
One of the most important subtotals is the OPERATIONAL PROFIT or EBIT (= Earnings Before Interest and Tax). To know what exactly is included in your own company, you can view the costs mentioned above. In general it can be said that the operating profit is the result of the "normal" activities of the company. This is therefore usually the most important performance measure for the management of the company.
The last subtotal of the Profit and Loss Statement is the NET PROFIT. All costs related to the revenue have been subtracted including the taxes and interest rates. Because these last two are normally the least related to revenue, they are at the bottom. The net profit is the amount that is left at the end of the period for the benefit of the owners of the firm, the equity. Note that this is not the same as money on the bank account. It concerns an accounting result of the activities that can be assigned to the shareholders or can be held as a buffer (= provision).
The operational profit represents the performance out of normal activities from the company. In contrast the operational cash flow which represents the cash flow from normal activities (also read the article about the Cash Flow). But how are the two related? The Profit and Loss is based upon the activities performed while the Cash Flow is based upon the money received. As discussed above the depreciation and amortisation are costs but no payment and are part of the investment cash flow not the operational cash flow. Therefore if you want to build a bridge from one to the other you have to start by adding the depreciation to the profit. This first step is called the EBITDA.
Is EBITDA a good yardstick for steering?
No! Why? Because it gives the impression that investments are "for free". By focusing on EBITDA, a lot of investments will be made that create insufficient cash inflow to recoup the investment. Should you apply EBITDA? Yes, but only if you know
what it stands for!
If you want to read more about assessment criteria, read the articles on Solvency, Liquidity and Profitability. Looking for something specific? Go to Top-100 Financial Management terms.
In this article I have outlined how the Profit and Loss Statement works. What is important to remember? First, it is an overview of realized minus consumed and has got nothing to do with cash flow. It always starts with what I have performed and then deducts that what I have used. I start with the costs that are easiest attributed to the performance. All subtotals are based on sales minus costs that are above. And most importantly: Why do you look at a Profit and Loss Statement? To judge how well do I perform? What happened? Where should I adjust? Which actions could I or should take? These questions are elaborated in the field that we call Management Accounting.
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