The profits in a company's financial statements assure the stakeholders of its profitability, making it a preferred investment option. But can the mere presence of profits certify that the company is a good investment option? No, it does not! These profits can be a result of selling vital assets or part of window dressing to hoodwink the shareholders. So, how do you know if a company is truly profitable? The answer lies in the ability to read its P&L statement and understand its financial health.
We have provided an insight into reading the reading balance sheets in part one of our series on reading financial statements in our previous article. Let us continue our journey into the next part of the financial statements. i.e., the Profit and Loss Statement. Check out this blog to learn key information provided in the profit and loss statement, its components and more.
The Profit and Loss Statement, also known as the Income and Expenditure Statement, is the second part of the financial statements of a company. It is a financial report that shows the income and expenses of a company during a specific period, usually a year or for an interim period like a quarter. This statement helps business owners, investors, and other stakeholders understand whether the company is making a profit or a loss. The P&L statement is one of the most important financial documents because it provides insights into a company’s performance.
The P&L Statement is divided into different sections representing the diverse components that highlight different key aspects of the business leading to its profitability. Here is a brief analysis of the same.
This is the starting point for the calculation of the profit or loss during the specified period under consideration. It refers to the total money earned by the company during the specified period from its core business activities. The revenue of the company is also referred to as the ‘top line of the company’ as it appears at the top of the statement and is vital for increasing the overall profitability of a company.
The revenue of a company can be further classified into two parts, namely, the operating revenue and the non-operating revenue.
Operating Revenue - This is the income earned from the company’s main business activities. For example, if a company sells mobile phones, the money earned from selling phones is the operating revenue.
Non-Operating Revenue - This includes money earned from activities outside the core business, such as interest income, rent received, or profits from investments.
This is the next part of the income statement, highlighting the direct cost of producing, manufacturing or purchasing the company’s products. It includes expenses like raw materials, manufacturing costs, and labour costs. A consistent increase in the COGS of the company without a complementary increase in its revenue will directly affect its profits in the long run.
This is the first test or point of profitability for a company. It is the resultant amount left after deducting the COGS from its revenue, and the formula is,
Gross Profit = Revenue - COGS
The gross profit shows the funds available for the company to pay for its indirect expenses to run the business, like rent, salary, marketing and distribution, and other administrative and general expenses.
The operating expenses or operating costs are the costs incurred by the company to run its daily operations. Some of the common examples of these expenses include,
Salaries and Wages – Payments to employees
Rent and Utilities – Cost of office or factory space
Marketing and Advertising – Expenses for promotions and branding
Administrative Costs – Costs related to office work and management
This is the next level of profitability, also known as the ‘Earnings before Interest and Taxes or EBIT’. It provides information on the amount left with the company after meeting its operating expenses but before the statutory expenses like interest and taxes. It represents the profit made by the company from its core business activities before accounting for the financial expenses incurred during the year.
The formula for calculating the Operating Profits is,
Operating Profit = Gross Profit – Operating Expenses
Interest expense is the amount paid by the company during the period against its outstanding loan. Higher debt levels lead to higher interest expenses and can have a direct impact on the net profits of the company.
Taxes refer to the tax liability to be paid by the company on its profits. This includes expenses like the advance tax paid during the year or yet to be paid. The tax liability is calculated on the net profit or the taxable income of the company as per the Income Tax Act and its amendments framed by the government from time to time.
This is the final profit earned by the company after deducting all the expenses incurred during the year. It is also known as the ‘Bottom Line of the company’ as it appears at the bottom of the statement. A company making consistent profits over the years is a positive sign for the stakeholders, while a company making a net loss is a big red flag that needs further introspection by the relevant stakeholders, like the management, investors, creditors, etc. The formula for calculating the net profit is,
Net Profit = Operating Profit – Interest – Taxes
EPS refers to the Earning Per Share, i.e., the profits available for shareholders per share. It is calculated as under,
Earnings Per Share = Net Profit ÷ Total Number of Shares
A higher EPS indicates better profitability and is often seen as a positive sign by investors.
The Profit and Loss (P&L) Statement is one of the most important financial reports for investors because it tells whether a company is making money or losing it. It shows the company’s total income, expenses, and final profit or loss over a specific period (usually a quarter or a year). The ability to read and understand the P&L Statement allows investors and other stakeholders to answer certain basic questions which can help them understand the financial health or the financial viability of the company and their investment in it.
Some of the key questions addressed in the P&L Statement include,
Is the company profitable? - A company with increasing net profit shows that the company is growing.
Is revenue growing? - A steady rise in sales revenue is a positive sign.
Are costs under control? - A company with expenses rising faster than revenue can be a problem.
Is the company efficient? - A company with good profit margins (Gross Profit, Operating Profit, and Net Profit Margins) show strong management and their ability to use the company resources efficiently.
While the P&L statement can show a company’s strengths, it can also reveal warning signs that investors should not ignore. Here are some red flags to watch out for.
Declining Revenue or Stagnant Growth
If a company’s sales revenue is falling over multiple quarters or years, it may indicate a problem. This could mean,
Falling demand for the company’s products or services
Strong competition taking away market share
Operational inefficiencies in production or sales
Increasing Expenses Faster Than Revenue
A company where the operating expenses (such as salaries, rent, and marketing costs) are growing faster than revenue can indicate the company is not managing its costs well.
High-Interest Expenses (Too Much Debt)
If a company is paying a lot of interest on loans, it could indicate financial stress. A high-interest expense compared to profit means the company is heavily dependent on borrowed money.
Declining Profit Margins
Profit margins (Gross Profit Margin, Operating Profit Margin, and Net Profit Margin) tell how much of the revenue turns into profit. If margins are shrinking, it can indicate
The company is selling at lower prices or offering discounts
Production or raw material costs are rising
The company is not managing expenses efficiently
A company should ideally maintain or improve its margins over time. If margins keep reducing, it may not be a good sign for investors.
Consistently Negative Net Profit or Losses
If a company is reporting losses year after year, it may struggle to survive. Some new companies (especially startups) take time to become profitable, but established companies should not consistently report losses. For example, if a company has a net loss for three years in a row, it may have serious financial trouble. Investors should check if the management has a plan to turn things around.
Frequent One-Time or Exceptional Expenses
Companies sometimes report one-time losses (such as penalties, legal costs, or restructuring expenses). While these are normal in some cases, frequent one-time expenses can be a red flag. If a company regularly shows ‘exceptional losses’ or ‘adjustments’, it may be hiding poor financial performance by blaming unexpected events. Investors should check if such expenses happen every year because if they do, they are not really ‘one-time’ expenses and need deeper introspection.
Manipulative Accounting Practices (Too Much ‘Other Income’)
If a company is making more money from ‘Other Income’ than from its core business, it may not be a good sign. ‘Other Income’ includes incomes like interest from bank deposits, rental income, or asset sales. For example, if a manufacturing company earns more from investments than from selling its products, it means the business itself is weak. Investors should focus on operating profit, not just overall profit. Similarly, any profits arising from changes in the accounting policies should also be scrutinised as they can be false profits and included in the financial statements as part of the window dressing or showcasing profits when there are none.
Even though profit and loss statements can provide an abundance of information, they also come with certain limitations. It is important for investors and other stakeholders to understand these limitations to evaluate this statement correctly and gain valuable insights.
These limitations include,
Ignores Cash Flow - Profits may not reflect actual cash availability.
Excludes Non-Financial Factors - Does not show brand value or customer loyalty.
Can Be Manipulated - Companies may manipulate the P&L Statement by adjusting revenues or expenses.
No Asset or Liability View - Does not show debt or asset efficiency.
Short-Term Focus - Covers only a specific period, not long-term health.
No Inflation Adjustment - Rising costs may reduce real profits.
Lacks Industry Comparison - Needs benchmarking with competitors.
The profit and loss statement helps investors and other stakeholders understand the company’s financial health by analysing the revenue, expenses and net profits. Evaluating the profit and loss statement also involves comparing the same with past statements for similar periods or comparing it with industry peers to analyse trends. Understanding this vital part of the financial statement is important for investors to make smart investment decisions.
This article is another addition to our series on ‘How to Read Financial Statements’. Let us know if you need further information on this topic or have any queries regarding the same, and we will address them.
Till then Happy Reading!
Read More: How do you do a fundamental stock market analysis?
Marisha Bhatt is a financial content writer @TrueData.
She writes with the sole aim of simplifying complex financial concepts and jargon while attempting to clarify technical and fundamental analysis concepts of the stock markets. The ultimate goal is to spread vital knowledge and benefit the maximum audience. Her Chartered Accountant background acts as the knowledge base to help clarify crucial concepts and create a sound investment portfolio.
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