The prime objective of any company is to make profits and to provide good returns to its shareholders. These profits are reported in the profit and loss statement of the company which is part of the mandatory financial statements that a company has to prepare every quarter as well as annually. However, it is not enough to check if the company is making profits, it is equally important to analyze the profit and loss statement to understand the trend of the company’s profitability and that of its key parameters. Given below are the details of how to read the P&L statement of a company to know if investing in such a company is a good bet.
Read More: All that you should know about Profit and Loss account
What is a P&L statement?
The profit and loss statement is the record of all the expenses and incomes of a company during a specific period of time usually a year. These reports are also prepared on a quarterly basis and the results of the same are declared by the company to the shareholders and other stakeholders. A profit and loss statement is also referred to as an income statement or the statement of operations. This statement is prepared based on the provisions of the Companies Act 2013, as well as based on core accounting principles like accrual accounting, matching principles, etc. This statement has to be reviewed by potential investors and lenders to ascertain the profitability and viability of a company.
What are the key components of a P&L statement and how to read them?
The profit and loss statement is made by comparing the total income and expenses of a specific period under various heads like the total revenues or sales of a company, gross margin, cost of goods sold, interest expense, taxes, etc. The interpretation of these components is mentioned below.
Revenue
This is the first component in the profit and loss or an income statement. This component is the record of all the revenues accumulated by the company in the given time frame (from all the business streams) and is also referred to as the top line of the company.
This component is crucial for a company’s survival; hence investors need to focus more on the company’s revenues. Furthermore, the revenues of a company cannot be analyzed on a standalone basis. It is important to make a comparative analysis of the company’s revenue with respect to its previous corresponding periods as well as in comparison to the industry standards. This will provide an understanding of whether the revenues of the company are increasing, decreasing, or have become stagnant.
Gross margin
The gross margin of the company refers to the gross profits where the cost of goods sold is reduced from the total revenues or sales. The gross margin of the company should not be negative as it implies that the company needs serious revisions by either increasing its sales or gross revenues or reducing its cost of goods sold. The gross margin of a company needs to be considered in comparison to the industry standards as well as previous accounting periods to ascertain if it has seen any growth.
Operating expenses
This is the next crucial component of a profit and loss statement that can either make or break a company. A comparison having a high gross profit may not have a high net profit or a profit at all if the operating expenses of such a company are high. Operating expenses refer to all the expenses that a company incurs to run its core operations. It includes general administration, sales and distribution, etc. The level of operating expenses of a business allows the investors to know the general cost of running the business which is in excess of the cost of production.
Operating margin
The operating margin of a company can be derived by deducting the operating expenses of the company from the gross margin. A positive operating margin is healthy for an organization as it has surplus funds to meet its mandatory obligations like interest and taxes.
Interest and taxes
As mentioned above, interest and taxes are mandatory expenses of a company that they need to provide irrespective of the availability of funds. A company having sufficient operating margin can easily meet these expenses and save being a defaulter. The interest expense has to be tracked thoroughly as it indicates the debt levels of the company which has to be under sustainable levels for its survival.
Net margin
The net margin of a company is the final profit that is available for the shareholders. A company having a consistently positive net profit margin is a good investment option for investors as well as for lenders as they have a proven track record of the company as an assurance of the viability of their investment. The net profit margin has to be compared to the previous period’s net profit margins which will highlight if the ultimate profits are increasing or diminishing over the years.
Analysis of budgets against actuals
Every company undertakes budgeting of its periodic expenses and thereby its profitability for such a period. This exercise helps in managing the avoidable and unavoidable expenses of the company as well as getting an idea of all the available resources to enable optimum allocation of the same. These budgets have to be compared to the actuals to identify the potential losses and avenues where the management needs to focus on cost-cutting and ultimately improve the bottom line for the company.
Example of a P&L account
Conclusion
A p&l statement is a key component of the financial statements of a company. This statement is a direct reflection of the company’s ability to make profits and provide returns to its shareholders. By reviewing and analyzing the profit and loss statement, investors, shareholders, lenders, and other stakeholders can ascertain if the company is going in the right direction of growth and its pace for the same.
FAQs
The net profits of a company are calculated by reducing all the accrued as well as incurred expenses of the company from its revenues for the specified period.
The EPS of a company is the earnings per share which are derived by using the following formula,
EPS= Net profit / number of shares of the company
The net profit of a company cannot be reviewed on a standalone profit and loss statement. It should be compared to the profits from the previous period as well as of its competition to decide if investing in the company is a good bet or otherwise.
Depreciation, although a non-cash expense, is an expense of the company nevertheless. Thereof it has to be included in the profit and loss statement even though it is excluded while preparing the cash flow statement.
