Getting Paid With the P&L Account
In this lesson, you’re expected to learn about:
– the main components of a profit & loss account
– gross profit, operating profit, and EBIT
– net profit and earnings per share
A company’s Profit & Loss Account works a lot like your personal finances – you start with the amount of money you make and then subtract all your costs to find out how much you have left.
The main difference is that a company’s P&L account includes more information than your personal income and expenditure account. In fact, a company’s P&L account breaks down how much money it’s making vs. how much it’s spending into six main groups.
Let’s briefly take a look at each of these groups:
The first section seeks to calculate the profitability of a company’s operations after direct costs (i.e. cost of sales). Its ultimate goal is to determine the company’s gross margin.
This includes all the money that a company makes from its primary operations – it doesn’t take into account any money the company makes from other activities outside of its core operations. Some companies refer to sales as turnover, revenueor other similar terms.
b) Cost of Sales (COS)
To make a product or provide a service, a company has to purchase supplies. Whatever its primary operation, every company adds up all the direct costs it incurs as a result of making its product or providing its service, not including indirect costs (sales costs, administration costs, research costs etc.) and this constitutes cost of sales.
1) First-In, First-Out (FIFO)
A company uses the costs of those things it purchased earliest when accounting for COS. In other words, the first stock items made or bought are the first items to be sold.
2) Last-In, First-Out (LIFO)
A company uses the cost of those things it purchased most recently when accounting for COS. In other words, the most recent stock items made or bought are the first items to be sold.
3) Weighted Average Cost (AVCO)
Cost of items held at the beginning of the period is calculated using the following equation:
AVCO = Total cost of goods in inventory / Number of items in inventory
The last component of the gross profit section is gross margin, which is obtained by subtracting the COS from sales.
It is all the money a company has left over from its primary operations to pay for overheads and indirect costs such as the sales staff, rent, supplies and everything else that isn’t directly related to the production or purchase of goods.
This section takes into account a company’s costs of doing business other than the cost of sales.
The overall goal of the operating profit is to determine how much money a company is making after taking into consideration all the costs the company incurs during its primary and supporting operations.
b) General & Administrative Costs: covers all the expenses of running a company. Costs that fall under this category are the salary of staff, costs of buildings, utilities, office supplies, insurance, equipment, maintenance and more.
c) Depreciation & Amortization: depreciation applies to tangible fixed assets while amortization applies to intangible fixed assets.
When doing business, a company incurs costs or generates income from a number of activities that aren’t related to its normal operations.
This section accounts for all these other costs and revenues, so that the company can make smart financial decisions on debt and knows how much to pay in corporation tax.
– Other income
– Other expenses
– Profit/loss on discontinued operations
It is essentially the total amount the company makes before lenders and the government get their hands on the company’s profits.
This section is arrived at after taxes and interest are taken into account. A company pays taxes on its profits after interest charges from lenders have been included in the P&L account. As a result, the company has to account for all other expenses and revenues and then it can include these final items and determine the company’s total profit.
These items go into calculating net profit:
– interest income
– interest expense
– tax on profits
The company has to choose whether to distribute the money from net profit as a dividend to its shareholders or to reinvest it into the company for improvements and expansion.
In this section, companies have to include the amount of earnings each individual share they have outstanding and owned by the shareholders has generated.
a) Basic EPS: calculated by dividing net profit attributable to shareholders by the total number of ordinary shares outstanding. This figure tells investors how much money each share they own earns during the period.
b) Diluted EPS: a company can issue a number of options that can eventually turn into shares. For example, employees may be given share options or convertible debt that may be converted into shares.
Sometimes events occur that alter a company’s profit but these either don’t have a place in the P&L account or they require additional disclosures to be made in order to see the full picture. Anything of this sort goes in the supplemental notes section.
For example, any discontinued operations or unusual earnings from subsidiaries.
Although other financial reports provide important information, the P&L account is the final test of whether a company is succeeding or failing in terms of making money.
It provides valuable information for tracking expenses and revenues, corporate revenue management and dividend policy. You can also compare the P&L of one company to that of other companies in the same industry to determine how competitive that company is within the industry as well as how it needs to position itself regarding price and volume of output.
When used along with other financial statements, the P&L contributes to a number of ratio analyses that measure how effectively a company manages its assets and how well the company yields returns on those assets.