What Is: The Profit and Loss Statement?
- What Is: Passive Investing
- What Is: Dollar Cost Averaging?
- What Is: Bottom-Up Investing
- What Is: Top-Down Investing
- What Is: Value Investing
- What Is: Growth Investing
- What Is: Income Investing
- What Is: GARP Investing
- What Is: The Rule of 72
- What Is: A Falling Knife
- What Is: Cyclical Stocks
- What Is: The Dividend Yield
- What Is: The Price-to-Earnings Ratio (P/E)
- What Is: The Cash Flow Statement
- What Is: A Share Split
- What Is: A Share Buyback
- What Is: Discounted Cash Flow
- What is: An Exchange-Traded Fund (ETF)?
- What is: A Hedge Fund?
- What is: The Balance Sheet?
- What Is: The Profit and Loss Statement?
- What is: A Limit Order?
- What is: A Two-Bagger
The profit and loss statement tracks a company’s revenues, gross profits, operating income or loss, and net profit for the period of time being reported.
The profit and loss statement is one of the four financial statements presented by a company to its shareholders, regulators, and the public on a quarterly, semi-annual, or annual basis. It shows how revenue is reduced to net profit through the subtraction of various expenses.
At the top (the “top line”) is revenue. This is the amount of recognized sales brought in by the company during the reporting period.
First, the costs associated with selling those items — the “cost of sales” or “cost of goods sold” — is then subtracted to arrive at gross profit. This includes:
- The cost of raw materials
- The cost of manufacture
- Shipping and handling costs to receive raw materials or to deliver finished goods, depending on the terms of such orders
Next, various operating expenses are subtracted from gross profit to arrive at operating profit. These include:
- Research and development
- Depreciation and amortization
- Selling, general, and administrative costs. These include:
- Selling expenses such as commissions to sales people
- Overhead, such as utility expenses
- Various salaries, such as those for management
Finally, various non-operating income and expenses are either added or subtracted from operating profit. These include:
- Interest expenses or interest received, sometimes reported as a “net” number.
- Income tax owed or credit received.
- After tax results for discontinued operations (such as a division sold during the reporting period)
- One-time gains or losses (such as writing down the value of inventory to reflect the market value or a gain or loss realized on the sale of some investments or capital equipment)
After all the expenses, the final or “bottom” line is reached, called net profit. This is how much profit or loss the company had during the reported period. To reach earnings per share (EPS), net profit is divided by the weighted average number of shares outstanding during the period.
Things to note
Almost all financial statements use the accrual basis accounting method. That is, revenue is recognized if the company meets one of several definitions for being able to state that a good or service has been “sold”, even though it actually hasn’t received the cash payment yet. The difference between what it has sold and what it has not been paid for at the end of the period would show up in the accounts receivable line on the balance sheet.
Similarly, expenses are “recognized” before the company actually pays for them. For instance, employees are owed salary or wages, even though they might not have been paid by the time the reporting period has ended. These expenses would be part of the selling, general, and administrative expenses as a non-cash expense and the amount owed would show up as a liability on the balance sheet under wages payable or, more probably, part of “other current liabilities.”
Depreciation and amortization is another non-cash expense, which spreads out the expense of purchasing some equipment over its useful lifetime as it is used to generate revenue.
All these non-cash expenses and incomes are reconciled through the cash flow statement.
Further, management has a certain amount of latitude in when it recognizes and how it classifies these various expenses and incomes. As a result, net profit can be manipulated by the company to present the best favorable face to investors.
One reason to do this is to “make the numbers.” That is, the company meets analysts’ expectations for revenue or income. Another reason is to “take a bath.” In this case, the company shoves all the bad results into one period so as to get it out of the way, suffer the pain of one bad reporting period only to come out clean afterwards. Not coincidentally, after taking a bath, the following year often shows up as being quite good, as it is easier to “beat” bad results.