How to read the profit and loss statement: A beginner's guide

Understanding the profit and loss (P&L) statement is like learning the cheat codes for decoding a company's financial game. It's the ultimate scoreboard that tells you if a business is winning or losing money.

Let's make this simple. Imagine you run a lemonade stand. How do you figure out if it's making money? The P&L statement is your go-to guide — it shows your sales, expenses, and profits. Whether it's a lemonade stand or a billion-dollar company, the concept is the same.

In this guide, we'll break down the P&L statement using the lemonade stand as an example. Let's dive in!

Revenue from operations

This represents the core income from the company's main business activities. For our lemonade stand, this would be the total money earned by selling lemonade. If you sold 1,000 cups at Rs 10 each, the revenue from operations would be Rs 10,000.

Revenue is our business heartbeat. While a steady increase indicates growing demand and better customer retention, a flat line indicates challenges such as market saturation and intense competition. However, revenue might be the topline but it's the bottom line (profits) that gets you the applause. Selling lemonade at Rs 10 and spending Rs 12 to make it is a total disaster!

Other income

This includes earnings from non-core activities. If the lemonade stand rents out its resources on holidays for Rs 1,000 or earns Rs 500 as interest on investments, that's other income. While not part of the primary business, it can add to overall profitability.

Think of other income as a cherry on top — it's sweet, but don't base your dessert on it. A company overly reliant on other income might lack a solid business model. Prioritise businesses with strong operational revenue!

Cost of materials consumed

This is the cost of inputs used in production. This includes lemons, sugar, and water — everything that goes into making your lemonade.

Track the proportion of these costs to revenue. If it's costing Rs 12 to make a Rs 10 cup of lemonade, you've got a problem. Watch this number closely — good businesses squeeze every drop of efficiency out of their inputs.

Purchases of stock in trade

If you buy pre-made lemonade bottles to resell alongside your own lemonade, the cost of these bottles is the purchase of stock-in-trade.

If your fridge is bursting with unsold lemonade bottles, that's a red flag. A business bloated with inventory is like a stand with too many unsold lemons — they'll spoil, just like your profits.

Changes in inventories of finished goods, work-in-progress, and stock-in-trade

Imagine your lemonade stand produces 1,000 cups of lemonade in Year 1, but you only manage to sell 800 cups. The remaining 200 cups remain unsold at the end of Year 1 and are counted as inventory. Thus, the production cost of the remaining 200 cups is deducted from Year 1 expenses. This cost will be added when you manage to sell this extra lemonade sometime in the future.

Growing inventory isn't always a sign of growth — it could mean you're stuck with unsold lemonade. A good business doesn't hoard; it sells.

Employee benefit expenses

If you hired someone to help sell lemonade and maintain other activities by paying them money, that's your employee benefit expense. For typical businesses, this includes salaries and wages, bonuses, contributions to provident funds, and welfare benefits.

Investing in skilled employees can enhance service quality and sales. However, rising employee costs without a revenue increase might indicate inefficiency. Employee-heavy industries such as information technology are prone to this risk. So they measure revenue generated per employee.

Depreciation and amortisation

Depreciation accounts for the wear and tear of tangible assets. If you buy a juicer for Rs 5,000, its value decreases over time due to wear and tear. Depreciation spreads this cost over its useful life, say Rs 1,000 annually for five years. Similarly, amortisation deals with intangible assets like patents or licences.

Check depreciation trends relative to capital expenditure (found in the cash flow statement). A mismatch could indicate overly aggressive asset write-offs or underinvestment in maintenance or upgrades. Ensure the business invests enough in maintaining or upgrading assets. A lemonade stand with a broken juicer will face operational challenges.

Other operating expenses

These include miscellaneous costs like renting the stand space, advertising, or electricity. If you spend Rs 1,000 on rent and Rs 500 on flyers, these are operating expenses.

Excessive operating expenses can erode profitability. For instance, if your stand's rent doubles, assess whether the location justifies the cost.

Earnings before interest and tax (EBIT) or operating profit

Operating profit, or EBIT, reflects the profit a company earns from its core business operations after deducting all operating expenses but excluding other income. For instance, if your lemonade stand generates Rs 10,000 in revenue and incurs Rs 7,000 in costs (excluding any interest earned on a savings account), your operating profit is Rs 3,000.

Why EBITDA is not operating profit

Many market participants and business media tout EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortisation) as equivalent to operating profit. However, Warren Buffett and Charlie Munger have strongly criticised EBITDA, calling it a "very misleading metric."

Buffett quips, "Does management think the tooth fairy pays for capital expenditures?"

EBITDA ignores depreciation and amortisation, which represent real business costs, especially for capital-intensive companies. For example, if your lemonade stand's juicer (costing Rs 5,000) requires replacement every five years, depreciation is an actual cash outflow over time. Ignoring such expenses gives a distorted view of profitability.

Always evaluate operating profit (EBIT) rather than EBITDA. It gives a more accurate picture of a company's profitability from its core business.

Suggested read: Adjusted EBITDA: Financial doping for loss makers

Finance costs

Finance costs include interest on loans and lease expenses. If you borrowed Rs 10,000 to start your lemonade stand and pay Rs 1,000 annually as interest, and you also lease a location for Rs 2,000 per year, the total finance cost is Rs 3,000.

A healthy business ensures finance costs are manageable relative to operating profits. If lease costs or interest payments eat up most of your earnings, it may signal over-leverage.

Exceptional items

These are one-time gains or losses. For instance, if you sell your lemonade stand's old cart for Rs 2,000, that's an exceptional gain.

Exclude exceptional items when assessing profitability. A one-time cart sale doesn't reflect the regular performance of your lemonade stand.

Profit before tax

This is your profit after subtracting all expenses except taxes. If your operating profit is Rs 3,000 and you pay Rs 1,000 in interest, your profit before tax is Rs 2,000.

While companies are mandatorily obligated to pay taxes, this figure is particularly effective for benchmarking companies on the same level, as it excludes the influence of tax strategies or any changes in tax laws.

Profit after tax

This is your net profit after taxes. If your profit before tax is Rs 2,000 and you pay Rs 900 in taxes, your profit after tax is Rs 1,100.

This money can be taken out by the owner or invested back into the business for future growth. Growing or stable earnings are often a hallmark of a resilient business. However, investors should always focus on long-term growth rather than being influenced by short-term fluctuations.

Earnings per share (EPS)

EPS represents the profit allocated to each share. If your lemonade stand earns Rs 1,500 and you and two partners each own an equal share, the EPS is Rs 500 (i.e., Rs 1,500 divided by 3).

Look for a steadily growing EPS. It signifies that profits are being shared fairly and consistently with shareholders.

Suggested read: Look at the EPS, not just profits

Diluted earnings per share (DPS)

If you have issued options for future ownership (e.g., your partner gets an additional share for helping expand), your diluted EPS adjusts for this potential increase in shares. With four shares instead of three, the EPS would drop to Rs 375.

A big gap between EPS and diluted EPS signals potential dilution risks. A strong business keeps dilution under control.

How do you find a company's P&L statement?

Understanding the profit and loss (P&L) statement is crucial for analysing a company's financial health, and Value Research makes it simple for you to access this information. On valueresearchonline.com, you can explore the P&L statements of thousands of Indian companies in an intuitive and user-friendly format.

Simply search for a company's name in the search bar, navigate to the "Financials" section on the company's profile, and select "Income Statement." Here, you'll find detailed line-by-line financials for multiple years, enabling you to track trends, compare performance, and make better-informed investment decisions. Whether you're a seasoned investor or just starting, Value Research offers the tools you need to make sense of a company's financial performance.

Your takeaway

The P&L statement is just the starting point. To assess a company thoroughly, you need to connect the dots between the other financial statements (balance sheet and cash flow statement), and key financial metrics like margins, ROE, and debt ratios. Qualitative factors like market position, competition, and management quality are equally critical. Stay tuned as we explore these in future articles!

Understanding financial statements is vital, but finding the right stocks goes beyond just the numbers. Value Research Stock Advisor provides you with carefully selected stock recommendations, in-depth analysis, and actionable insights to help you build a winning portfolio. Take the guesswork out of equity investing and let Value Research Stock Advisor guide you to smarter decisions. Start your journey today!

Also read:
Decoding revenue and P&L statements of general insurers
Understanding financial statements

This article was originally published on December 09, 2024.