Welcome to our series on Business Turnaround tips. In this post, I’m going to do a very basic overview of one of the financial statements – the Profit and Loss statement (otherwise known as the P&L statement). In this Profit and Loss Statement 101, I will show you the purpose of the profit and loss statement, how to read one and what you should be looking for in a business turnaround situation. Are you ready? Let’s dive right in.
Profit And Loss Statement 101
Purpose: The Profit and Loss (P&L) is the statement used to measure how profitable (or unprofitable a business is).
This is a very basic example of a Profit and loss statement. I’ve used the example of a manufacturing company just for illustration purposes.
The 2 Different Types Of Accounting
In accounting, there are 2 methods of doing a profit and loss statement:
- Accruals-Based Accounting
- Cash-Based Accounting
This is the most popular method of accounting. It simply means that you recognise income and expenses when they are incurred, not actually received or paid out.
For example, let’s say we’re in the month of July. You make a sale of £1,000 and raise the invoice. On the accruals method, you will recognise the £1,000 in the Turnover section – even though it’s not been paid. That’s income you’ve generated and we will expect that money later down the line. (Remember, most invoices have payment terms of 30/60/90 days to be paid). If you raise the invoice in July, you might not see that payment hit your bank account until August, September or November but it will appear on the profit and loss statement as a sale.
Similarly, expenses are recognised on the profit and loss statement when they are incurred, not necessarily when you make the payment. Again, not all payments are due that month, but we recognise that at some point we have to pay it.
This is more popular with smaller businesses that operate more on a quick transaction. This is more of a ‘real-time’ accounting method that recognises income and expenses when they actually happen. So using our previous example – if you raised an invoice for £1,000 in July, on the cash-based accounting, you won’t put it on the profit and loss statement until you actually receive the money in the account.
Similarly, with expenses, you won’t recognise it on the profit and loss until you actually pay the money out.
The Different Types of Profit
In a Profit and Loss Statement 101, we must talk about profit and clear up the confusion surrounding it. The Profit and loss statement is used to see how much profit or loss a company makes. Simple right? However, it’s important to note that there are different types of profit:
- Gross Profit (GP)
- Earnings Before Interest, Taxes, Depreciation and Amortisation (EBITDA)
- Earnings Before Interest and Tax (EBIT)
Gross profit is the first type of profit we see on the profit and loss statement. It’s the ‘top line’ profit because it’s near the top of the statement. Clever right?
This profit and loss example shows a company that is making sales of £500,000. After you take out ‘Cost of Sales’ it is left with a gross profit of £200,000. Cost of Sales is whatever you spend to make the sale e.g. raw materials, ingredients, packaging, marketing budget etc.
The gross profit (GP) is calculated by the following:
Turnover – Cost of Sales (COS) = Gross Profit
When you look at your gross profit (or gross profit margins) you can quickly see if you are paying too much for your COS. Check out this post where I show you how to increase your gross profit.
Earnings Before Interest, Tax, Depreciation and Amortisation (EBITDA)
EBIT-who? This is the next type of profit. From the gross profit of £200,000, you have some more things to pay out in the form of operating expenses. This could be things like rent, rates, utilities, software, wages etc. So the EBITDA is the profit you’re left with after you’ve paid the operating expenses and other expenses. In the example above, we can see that we have operating expenses of £50,000. Therefore the EBITDA is £20,000 (gross profit) minus the £50,000 (operating expenses) which leaves us with £150,000. The EBITDA is £150,000.
Earnings Before Interest, Tax (EBIT)
The accountants will factor in depreciation of your assets (machinery, computers etc) because over time they decrease in value. They can’t give the exact value so they make an educated guess. In this example, they have factored in depreciation and amortisation of £5,000. This means that the EBIT is our EBITDA figure of £150,000 minus the £5,000. Therefore our EBIT is £145,000.
Net Income – The Bottom Line
Finally, we have to pay interest and tax. This is the last bit to pay before you’re left with the bottom line. The net income is what you are left with after you’ve paid everything you need to. In the example, you can see that the earnings before tax (EBIT) is £145,000 but now we have to pay interest and tax of £65,250. Therefore your net profit is £145,000 minus £65,250 giving you a net profit of £79,750. That’s your bottom line.
Which Profit Are You Talking About?
Whenever someone is talking to you about profit, it’s always important to specify which type of profit they are referring to. As you can from this example, someone may be trying to paint you a lovely picture of £200,000 profit (gross profit). If you’re not careful, you could be operating under the assumption that you have more money than you actually have. Don’t forget, you may have £200,000 gross profit at that stage in the profit and loss statement, however, you still have to pay out operating expenses, tax and factor in depreciation. If you’re wanting the bottom line, ask for it. Ask your team to be clear about the type of profit they are talking about.
Finance and accounting are just like anything else – they can be learned and you just have to practice. I always recommend reading ‘Finance for Non-Financial Managers’ by Gene Siciliano. This book has personally helped me in my journey to learning Finance and Accounting and has helped many other senior professionals who want to develop their commerciality. Go ahead and buy the book using the link below. You won’t be disappointed.