The profit & loss account explained.

The Profit and Loss Account (P&L) or the Income Statement to our friends from across the pond is one of three core financial statements that provide vital information on the health and potential of a business. The P&L indicates the profit (or loss) generated from business transactions over a time period.

They summarise the financial activity reading from the top-down like a funnel, we start with revenue at the top and the profit at the bottom. There are three sections of a P&L revenues (income), expenditures (both indirect and indirect costs – more later) and the difference between the two that give you your company profit and a key measure of the value that is created to the Shareholders.

Let’s work our way down :

Revenue (AKA Turnover, Income, Sales or the Top Line)

This is all the sales that you made in the defined period whether this is from selling products, subscriptions, services or anything – the sales for the time period are recorded here.

Direct Costs (AKA Cost of Goods Sold (COGs), variable costs, gross costs)

The costs associated with generating the revenue in the time period and so fluctuate with revenue – this could be the cost of making (or buying in) a product, the cost of direct labour involved in delivering a a service or costs that will generally fluctuate with Revenue such as payment processing etc.

Now time to introduce some (basic) maths,

Revenue – Direct Costs = Gross Profit and our first financial ratio –

(Gross Profit / Revenue) x 100 = The % Gross Profit Margin

Gross Profit

This is an indicator of your business’s ability (by your revenue) to cover the costs of providing your customers with your goods or services. Another way to look at this, at a unit level, is the margin between your price and direct costs. The higher the Gross Profit Margin, the more efficient the production process of the business. Where a company can increase the price without having to increase the direct costs this margin will increase.

Indirect costs (AKA Operating Expenses (OpEx), Overheads)

These are the costs that relate to the day to day running of the business and do not (on the most part) fluctuate with revenue. These include fixed costs such as employee salaries; meals and entertainment; travel and training; office space rental and utility costs;

More Maths – Gross Profit – Indirect Costs = Operating Profit and our second financial ratio – (Operating Profit / Revenue) x 100 = The % Operating Profit Margin

Operating Profit AKA EBITDA, that Earnings Before Interest Taxation Depreciation & Appreciation (we’ll get to this)

This can also be calculated by Revenue minus Direct and Indirect costs – in other words “what did you sell” minus “how much it cost you to supply your goods/services” and “how much it costs to run your business.”. This shows how profitable your operations are including all your core expenses. As profitability is a key determinant of long-term survival, this is an important KPI. The operating profit margin is normally the first port of call for any investor at it shows how well the business is covering you costs. If you can reduce your costs while keep your revenue constant – the margin will increase.

Operating profit is also know as EBITDA, this is where the P&L makes the necessary accounting adjustments (and some “paper” i.e. not actual cash adjustments) to get to the Net Profit (the bottom of the funnel, hence the bottom line). Taking each one by one, we have Earnings Before (that’s the ‘E’ and ‘B’ covered)

Interest – when you take a loan out, you normally pay interest at an agreed % rate
Taxation – if you turn a profit you will pay corporation and other taxes, the rates are dependent on where you are
Depreciation – when you buy an physical asset (e.g. a car) as it gets used, its value goes down and the reduction in value is recorded
Amortisation – when you invest in a non-physical asset (e.g. patent) a it will lose it’s value over time and the reduction in value is recorded
and now let’s work down to Net Profit:

From EBITDA, we take off Depreciation and Amortisation which gives us

EBIT (Earnings Before Interest and Taxation), next we remove the Interest to get

EBT (Earning before…you’ve guessed it!…Taxation) and once we remove the taxation, we get to…

Net Profit and that’s it – the Bottom Line .

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