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Profit and Loss Report: Analysis and Interpretation

General information on profit and loss report

Profit and loss report (often referred as P&L report, income statement, or statement of operations) is one of the primary reports in the system of enterprise accounting, which plays an important role in the financial statement analysis. It contains summarized information about firm’s revenues and expenses over the reporting period. Most common are income statements that contain the quarterly and yearly information. The goal of the statement of income is to measure the profit of a business over the reporting period by excluding the expenses of a firm from its revenues.

The general form of P&L report starts with the revenue entry, from which the operative expense, salary, depreciation expense, interest expense and other expenses are being subtracted in order to compute the net earnings in the end. The net earnings are presented as an absolute value, and also as the division of net earnings by the number of shares outstanding (earnings per share). Both horizontal and vertical analysis can be applied to the income statement; as the P&L report most commonly contains quarterly information, the ratios calculated can be analyzed in dynamics over some time and for some certain reporting period.

Basic elements of the profit and loss report are:

1. Revenue (Net Sales). This entry represents the value of goods or services a company has sold to its customers. Commonly sales are presented net of different discounts, returns, etc.

2. Cost of Goods Sold. This element measures the total amount of expenses, related to the product creation process, including the cost of materials, labor, etc. Costs of goods sold include direct costs and overhead costs. Direct costs (materials; parts of product purchased for its construction; items, purchased for resale; labor costs; shipping costs, etc.) are the expenses that can be actually associated with the object and its production. Overhead costs (labor costs, equipment costs, rent costs, etc.) are the expenses that are related to the business running process, but cannot be directly associated with the particular object of production.

3. Gross Profit. Gross profit is net revenue excluding costs of goods sold.

4. Operating Expenses. Operating expenses include selling and administrative expenses. Selling are the expenses, which relate to the process of generating sales by a company, including miscellaneous advertisement expenses, sales commission, etc. All the expenses connected with company’s operation administration, such as salaries of the office employees, insurance, etc., refer to the administrative expenses.

5. Operating Income. Operating income is gross profit excluding operating expenses.

6. Other income or expense. This entry contains all the other income or expense values that weren’t included to any of the previous entries. It may be dividends, interest income, interest expense, net losses on derivatives, etc.

7. Income Before Income Taxes. Income before income taxes is operating income including (or excluding) other income or expense.

8. Income Taxes. This entry includes all state and local taxes, which are based on the reported profit of an enterprise.

9. Net Income. Net income is the amount of money remaining after taking the net sales of a business and excluding all the expenses, taxes depreciation and other costs. In other words, this entry reflects the basic goal of an enterprise functioning – its profit. It is also often referred as net profit or net earnings. Following the net income in the profit and loss report is a very important part of the company’s financial report analysis.

10. Earnings Per Share. This entry is often included at the end of P&L report. It reflects the net profit as its division by the total number of shares outstanding. The result is the amount of net profit, earned by one share of common stock. This measurement can be useful for the risk management of a stockholder.

Profit and loss statement analysis: financial ratios calculation and interpretation

The income statement of the firm contains information that can be used for computation of certain financial ratios, which measure firm’s performance and position over the reporting period. Depending on the ratio, it can be a measure of firm’s profitability or financial sustainability.

Gross Margin

Gross margin is a percentage, which can be calculated as company’s net sales divided by the costs of goods sold. In other words, it’s a ratio of the gross profit and net revenue. The formula for its calculation is as follows:

Gross Margin = (Net Sales – Costs Of Goods Sold) ÷ Net Sales

An alternative formula for this ratio computation is as follows:

Gross Margin = Gross Profit ÷ Net Revenue

The presented ratio shows the percentage of the net revenue, remaining after the exclusion of the expenses, related to the product creation process. Normally gross margin ratio is different for different companies, or industries. Obviously, the firm is interested in high gross margin, because this would mean that it increases the gross profit by making the costs of goods sold lower, or by increasing the trade margin; high gross margin would also indicate a positive impact on company’s net income.

Profit Margin (after taxes)

Profit Margin is a ratio, which measures the amount of profit (after the deduction of all the expenses and income taxes) per 1 dollar of sales. It can be computed with the use of the following formula:

Profit Margin = Net Income After Taxes ÷ Net Sales

This ratio fluctuates between different industries, but the higher profit margin is obviously desirable.

Earnings Per Share

Earnings per share ratio demonstrates the amount of the net profit of a company per one share of common stock and can be computed as follows:

Earnings Per Share = Net Income After Taxes ÷Average Number of Common Shares Outstanding

As said before, this ratio is very closely followed by company’s stockholders (or potential investors) because it is an important criterion for the risk management. Both company owners and shareholders are interested in earnings per one share of common stock to be high.

Times Interest Earned

Indicating firm’s debt-paying ability, this ratio measures the income amount available for covering the future interest expenses. The computation formula is as follows:

Times Interest Earned = Earnings for the Year before Interest and Income Tax Expense ÷ Interest Expense for the Year

Although, the ratios may vary for different industries, most commonly higher ratios are preferable. If a firm has normal times interest earned ratio, it has lesser risk of not being able to meet its interest obligation. High and stable times interest earned ratio over years means the company is financially sustainable and most likely has no problems paying its obligations.

Return on Stockholders’ Equity (after taxes)

Often simply referred as return on equity, this ratio is widely used during the performance of the analysis of firm’s profitability. It reflects company’s ability of profit generation from the investments of its shareholders. This ratio can be calculated with use of the following formula:

Return on Stockholders’ Equity (after taxes) = Net Income for the Year after Taxes ÷ Average Stockholders’ Equity during the Year

Both shareholders and management of the company are interested in high return on equity. The more profit is generated from 1 dollar of investors’ funds, the more efficient is the management of these funds.

Summary

Profit and loss report is one of the primary reports of the financial statement of a company, summarizing its revenues and expenses. It measures firm’s profit over the reporting period and can be an object of the horizontal and vertical analysis in order to determine the position of a company.

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