the profit and loss statement

8/12/2019 The Profit and Loss Statement

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The Profit and Loss Statement: What Does It

Mean?

CDFS-1153-96

Small Business Series

Marianne M. Huey

Overview

The Profit and Loss (P&L) Statement is also known as the Income Statement. It shows how well

a company buys and sells inventory (or services) to make a profit. A firm must create a profit inorder to survive and remain solvent. Careful analysis of the components of a P&L is important in

determining the cash flow available to repay existing debt, finance additional debt (for business

expansion), or to reinvest in the company.

Just as the Balance Sheet (see Balance Sheet Fact Sheet, CDFS-1154) is a snapshot of thefinancial condition of a company at a certain point in time, the Profit and Loss statement shows

the results of financial operations over a period of time. The amount of time could be a month, a

quarter of a year, a half year, or a year.

Profit and Loss Statement Format

The categories of a profit and loss statement are arranged in a specific order regardless of the

legal form of the business (i.e., sole proprietor, C corporation, etc.). Within each category,revenues and expenses may be listed separately or grouped. Financial reporting needs to remain

consistent over a period of time. Listing the same type of expense under different headings year

after year may raise a red flag.

Expense Categories

The following is a typical P&L statement. Each expense category is made up of either variable,

fixed, or "discretionary" expenses.

The Cost of Goods Sold (COGS)is the general category for all production related expenses

which is subtracted first from sales. COGS is defined as:

COGS = (Beginning Inventory) + (Purchases of Inventory) - (Ending Inventory)

For the manufacturing firm, the "Purchases of Inventory" would include the raw materials anddirect labor used to produce a product.


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Sales

- Cost of Goods Sold (variable)

= Gross Profit

- Selling & Gen. Admin. (fixed/period)

= Operating Profit

- Officer Salaries (discretionary)- Interest (discretionary)

- Depreciation (discretionary)

- Rent (discretionary)+/- Other Income/Expenses

= Earnings Before Tax

- Taxes

= Profit After Tax

Completing the computation results in the Gross Profit(Sales - COGS). At this point, allproduction related expenses are covered and the remaining overhead costs associated with

business operations must be subtracted in order to determine the company's Earnings Before Tax

(EBTx).

The Selling, General and Administrative (SG&A)category contains fixed, variable, and

discretionary expenses and may include:

Salaried personnel Travel and entertainment Rent Utilities Postage Printing Insurance Interest Depreciation Dues/Subscriptions Advertising

It is a mixture of many different things and thus, difficult to analyze. Most often, the expenses

listed under SG&A tend to remain fixed over a relevant range of time. However, watch for

variability as production levels increase significantly or sales change.

Taking a Closer Look

Simply stated, profits are equal to the difference between revenues and expenses:

Profits = Revenues - Expenses


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To understand how well a company buys and sells inventory or services to make a profit, onemust look at the types of expenses being charged against revenues and ask whether or not these

are being recorded accurately and consistently. For analysis purposes, expenses are classified as

variable, fixed, and discretionary.

Variable Expenses

Variable expenses are directly affected by sales. They are the production-related expenses, such

as raw materials, direct labor, commissions, and shipping. On the P&L, they are listed as the"Cost of Goods Sold" (COGS) and are typically the largest expense category.

Fixed Expenses

Fixed expenses are constant. They do not vary with sales or production. They are the basic

overhead costs of the company, such as utilities, insurance, postage, etc., which are chargedagainst revenues on a periodic basis (weekly, monthly, annually). On the P&L, fixed expenses

are listed under the heading, "Selling, General and Administrative" (SGA) and may containseveral different categories.

Discretionary Expenses

The National Development Council, specialists in economic development finance and business

credit analysis training, proposes a third type of expense classified as "discretionary."

Discretionary expenses are those which the business owner may control in order to decrease thereported profits.

When looking at the P&L, the following expenses are separated from the SGA for furtheranalysis:

Officers' Salaries Interest Expense Depreciation Rent

A closer look at these items provides one with the questions to ask the entrepreneur.

Officers' Salaries.As a specific line item in SG&A, has this amount increased or decreased over

the years? It is usually a difficult question to pose in as much as, how much is too much for

officers to be paid? Or, are they willing to decrease their salaries in order to free up additionaldollars in the company?

A careful analysis of the financial statements may reveal additional forms of officercompensation including dividends, travel and entertainment expenses, rent expense (officers own

the facility where the company is housed), interest on officers' loans to the company, pension

fund investments, and others. When officer salaries are low, there are usually other forms ofcompensation.


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Interest.Interest is a discretionary expense item only when the amount of debt a company carries

increases, decreases, or is refinanced. If a company restructures existing financing or pays off a

loan, the interest expense may be less. However, this may be offset by any additional debt the

company incurs due to a business expansion project (which is primarily interest expense in theearly stages of the loan). Interest expense should be looked at carefully because it is usually

affected by new financing.

Depreciation.Depreciation is a non-cash expense which reflects the "wearing out" of assets over

time. When assets are purchased (with the exception of land), they are useful to a company for a

limited number of years. The cost of each asset is expensed over the period of time during whichservices are received from the asset. The purpose of depreciating an asset (even though no actual

"cash" is paid) is because at the point in time when the asset wears out, a new cash payment must

be made in order to replace the asset.

Different assets have different depreciation schedules (or "useful life" as defined by the Internal

Revenue Service). If a company is profitable, it may accelerate depreciation in order to reducereported profits. Because depreciation is a non-cash expense, a cash payment is not made by the

company to "Depreciation," and more dollars are available to invest in new assets.

When analyzing depreciation, generally the total amount is not available for debt service. Some

depreciation should be allocated for replacement purposes and short-term asset purchases.

Rent.Rent expense may be discretionary for several reasons. First, the company officers may

own the building or facility and rent it to the business. Typically, the amount paid in rent is

enough to cover the debt service on the building and other associated expenses, such as real estatetaxes and insurance, which may or may not be included in the lease agreement.

If the amount charged to rent over a period of time (historical financials) has increasedsignificantly, questions should be raised. Have the expenses actually increased or is the

corporation attempting to decrease reported profits and thus, pay less in taxes? Furthermore, is

there any debt on the building or do the officers own the building free and clear and simply rent itto the company? If this is the case, could they forego the rent payment, leaving more cash in thecompany?

Second, the company could eliminate rent payment by purchasing the building they are currently

leasing. Cash which was used to make a monthly rent payment would be available to the

company.

Discretionary Expenses are "Fudgeable"

Carefully examining the expense categories of rent, officers' compensation, interest, and

depreciation may uncover "hidden" cash flow available to repay proposed new debt. These

particular expenses, when compared to other less flexible categories grouped under Selling,

General and Administrative, are fudgeable. In other words, they may be manipulated to eitherreduce or overstate the reported earnings before tax of a company.


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A company may overstate expenses in order to reduce the amount of earning before tax and thus,

lower the company's tax liability, or a company may want to understate officers' salaries and

other expenses which would increase the earnings before tax (overstate profits), and thus, give

the illusion of debt capacity. A careful look at the discretionary expenses and how they arecontrolled is critical to understanding the profit and loss statement.

References

the profit and loss statement

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