Cash Crisis

Performance Support:
How to Analyze a Profit and Loss Statement
This support was prepared by subject matter experts with experience analyzing profit and loss
statements. It describes the data included in a profit and loss statement and provides an explanation of
how to analyze that data.

Overview
What is a profit A profit and loss statement (P&L), also known as an income statement,
and loss describes a company’s financial results over a specific period of time, typically
statement? one year. The main purpose of a P&L is to provide information about a company's
performance—to demonstrate whether the company’s operations have resulted in
a profit or a loss.

Careful reading of a P&L can also reveal more subtle information, such as
whether a company is generating enough cash to fund business expansion and
repay debt. Knowing how to read and analyze a P&L is a crucial part of the
financial analysis of a business.

 A traditional P&L indicates how revenue is transformed into net income.

o Revenue, sometimes called the “top line,” refers to a company’s
earnings from products and services before any costs or expenses
are considered.
o Net income, also known as the company’s “bottom line,” refers to
the amount of profit earned after all costs and expenses (such as
production costs, staff wages, loan payments, and taxes) have been
deducted.

 A P&L can aid financial analysts in forecasting a business’s future

performance and in making suggestions for improvement.
o When the P&Ls for several consecutive periods are viewed at once,
analysts can spot trends. For example, an analyst might note
whether a company’s net income has increased, decreased, or
remained constant over several years. Once trends are spotted,
problems are easier to pinpoint and remedy.

Who uses a P&L, A P&L is viewed by many stakeholders, each of whom has a direct interest in a
and why? company’s economic results.

 Public administrations, such as the U.S. Internal Revenue Service,

often review a P&L to determine a company’s profits for taxation
purposes.

 Company administrators need to know how efficiently the company

is producing. They must determine how much profit may be retained
and reinvested in order to keep the company competitive.

 Shareholders examine a P&L to gauge the return on their investment

in the company. The portion of profits a shareholder receives is
commonly referred to as a dividend.

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 Lenders, such as banks, must make sure that the company will
generate enough cash to repay its debts.

Detailed Examination
What, specifically, A P&L presents data that describes how a company’s operations affect results.
does a P&L This data is presented as a series of margins. A margin can be defined as the
measure? difference between income and cost. The margins included in a P&L show how
the company’s activities have resulted in a profit or a loss. A P&L typically
contains the following margins:

 As noted above, total revenue refers to a company’s earnings from its

products—it is the sum total of all sales during a given time period.

o Total revenue is made up of all earnings a company generates

from both its principle activity—the main product or service it
sells—and from any other, more minor sources of revenue.
These more incidental revenue sources are not related to the
company’s principle activity; they are usually grouped together
into the line item “other revenue” on a P&L.

o As well as reflecting the sum total of all sales, total revenue also
takes into account inventory variation—any increases or
decreases in inventory.

 An increase in inventory on a P&L indicates that the

company has produced more than it has sold. Though
the company has paid to produce the goods, it has not
received payment for them. To compensate for this, the
company essentially “sells” the finished inventory back to
itself, at a price that equals the cost incurred in producing
the goods. This impacts total revenue—it shows up as an
increase in revenue on the P&L. When you examine a
company’s total revenue and see that it is increasing, it is
important to discern whether the increase is a result of
higher sales, or the result of an increase in inventory.

 When a company sells more than it produces, this is

reflected on the P&L as a decrease in inventory. This
decrease is subtracted for the company’s total revenue.
However, since the inventory line item only takes into
account the cost of producing the goods, in a case like
this, you will notice that sales will rise at a higher rate.

 The next margin, earnings before interest, taxes, depreciation and

amortization, is usually shortened to EBITDA. Many analysts believe
that EBITDA is the most critical margin on a P&L, because it reflects how
the core business of the company is performing—it demonstrates a
company’s ability to generate income from operations. EBITDA is
essentially the money a company has made on the sale of goods, less all
costs required to produce those goods.

o The many costs a company incurs are often broken down into
cost groups, so that one can tell at a glance which major costs—
production costs, or sales costs, for example—are most affecting

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a company’s financial situation.

 The cost of goods produced refers to the direct costs

incurred in the production of the goods to be sold. Direct
costs include the cost of raw materials and other
purchased goods required to make the company’s
product, as well as direct labor costs, or the cost of
personnel directly involved in production.

 Total selling expenses are the costs required to find

customers, convince them to buy the product, deliver the
product, and collect the amount due. This cost category
includes sales staff salaries, sales commissions, and
discounts.

 Discounts are a common sales practice. As a

company increases its production, it will need to
capture a bigger share of the market in order to
sell its goods. If a large buyer wants to purchase
a large volume of goods from the company, the
buyer will often ask for a discount—a lower than
usual price—on the merchandise. A company
that wishes to increase sales by selling to large
buyers will often have to grant these discounts.
However, this is a practice that must be carefully
monitored and balanced by a company’s
management. If a company fails to defend its
price point—if it gives too many discounts—the
discounts can have a negative impact on profits.

 Total other operating costs, also referred to as indirect

overhead, refers to administrative and other costs that
are not directly related to the production of goods.

 One specific type of cost included in this cost

group are provisions, or funds a company sets
aside to pay for liabilities expected to occur in a
given time period.

o Although EBITDA is a crucial indicator for managers, investors,

and analysts, it is not a defined measure under common
accounting rules, such as Generally Accepted Accounting
Principles (GAAP). This is an example of one of the slight
differences between managerial accounting and financial
accounting that you will become accustomed to differentiating.
(Managerial accounting is concerned with providing information
to people inside a company who direct and control its operation.
Financial accounting is the way auditors and certified
accountants present financial statements according to general
accepted rules for public information.).

 Earnings before interest and taxes, commonly shortened to EBIT, is

also sometimes referred to as the net margin or net operating profits.
EBIT shows the result of deducting depreciation and amortization from
EBITDA.

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o Depreciation refers to the decline in value of tangible assets.

 For example, imagine that a small transport company
buys a truck, which they will use for ten years before
replacing. The company has to include, as a cost of
business, the depreciation of the truck at 10% every year.
Thus, at the end of ten years, the truck is devalued.

o Amortization refers to the decline in value of intangible assets.

 For example, imagine that a company holds the patent
on a new invention for just twenty years, at which point
the patent will expire. Once the patent expires, this
intangible asset has declined in value, or amortized.

o It is important to note that different countries treat amortization

and depreciation differently. For example, in the United States,
the two are usually noted separately on a company’s P&L. In
Spain, however, amortization and depreciation are combined and
presented as one line item.

o Amortization and depreciation are costs that do not affect cash

flow—the balance of cash being received and paid by a
business—because they are not actually paid to anyone. As a
result, EBIT shows the capacity the company has to pay interest
to their lenders and taxes to the government.

 Earnings before taxes (EBT) are also commonly referred to as pre-tax

income. An important aspect of EBT is the way in which it nulls the
effects of the different capital structures and tax rates used by different
companies. By excluding both taxes and interest expenses, EBT hones in
on the company's ability to create profits, and thus makes for easier
cross-company comparisons.

o EBT shows the impact that financial expenses and extraordinary

expenses have on the company’s finances—it is essentially
EBIT, less any extraordinary items and financial expenses the
company has incurred.

o An extraordinary item is a profit or loss that does not reflect a

company’s usual business operations.

 Crop destruction due to a tornado, for instance, would be

described as an extraordinary expense. Extraordinary
expenses are often unavoidable.

 A one-time profit made on the sale of land not directly

connected to the business is an example of
extraordinary income.

o Financial expenses refer to the money a company must pay to

acquire funds. The most common example of this is the interest a
company pays to a lender in order to secure a loan. Financial
expenses increase in accordance with the total amount of debt
the company incurs and the interest rate charged by its lenders.
Growing financial expenses can be detrimental to a company’s
profits.

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 Net income refers to the company’s final earnings after accounting for all
the costs incurred in producing the goods, selling them, administering the
company, deducting the depreciation and amortization of assets and
paying both the lenders and the government. It is the company’s final
earnings for the year—the company’s “bottom line.” This result can be a
profit, if the balance is positive, or a loss, if the balance is negative.
o A negative net income usually indicates that the company’s sales
are too low or that its costs are too high (or a combination of
both).

Process

Analyzing the A common practice when beginning an analysis of a P&L is to consider the figure
P&L: How should I for total revenue as 100%. Then, all other margins in the P&L can be described
begin my as a percentage of total revenue.
examination?  For example, imagine that a company’s total revenue is $30 million,
and its EBITDA is $6 million. If the figure for total revenue is set as
100%, then this company’s EBITDA is 20% of its total revenue.

This practice makes it easier to compare the same items in P&Ls from different
fiscal periods. It also makes it easier to compare different items within one P&L.
These two modes of comparison are called horizontal analysis and vertical
analysis.

 Horizontal analysis involves examining a specific item or margin over

time and noting changes.
o For example, net income may be compared over a period of
several years, or selling expenses may be compared over several
months within one year. Once a series of changes, or a trend, is
noted, analysts can dig deeper and begin examining the direction
and speed of that trend.

 Vertical analysis refers to the identification of items in the financial

statement whose impact on net earnings is significant or unusual and
should be analyzed further. An item that represents 1% of the cost of
sales would usually not be considered significant. An item that represents
80% of the cost of sales would be significant.
o For example, in a retail operation, the purchase of material goods
that are later sold should represent a significant proportion of the
total costs. In a service company, personnel costs should be the
most significant. If this were not the case, an analyst would want
to look further in order to understand why.
o Items which have a significant impact on net results might be
benchmarked against other companies in the same industry, in
order to see how well the company is performing relative to its
competitors. When a financial analyst belongs to a large
corporation, such as the risk department of a large bank, he or
she may have access to significant amounts of information on
different companies within one industry. The analyst can then
benchmark, or compare the financial situation of the company
under analysis with the best performers in that particular industry.

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Interpreting the As you carry out your own analysis of the P&L, examine each margin and
P&L: What consider the following questions:
questions should I
be asking?  How has the margin evolved over the period under analysis?
o Look for positive or negative trends in the margin’s progression, both
in absolute terms and in relative terms.
o When you analyze a margin in absolute terms, you isolate one
specific margin and examine it in a non-comparative way.
 For example, you might look at how the cost of raw
materials has increased or decreased over a period of
four years.
o When you examine a margin in relative terms, you look at how it
has behaved in relation to other margins.
 An example of this analysis would be looking at the cost
of raw materials over four years, and then examining this
cost in relation to the company’s total revenue during the
same four-year period. If total revenue, or the cash made
on sales, has remained constant while the cost of sales
has risen sharply, the company has a financial problem
to rectify.

 How is each cost component affecting the margin?

o Examine each cost component of the margin—in other words, each
line item directly above it—in order to identify which costs are
causing the most significant variations in the margin from one year to
the next.
o For example, if you find that a company’s EBITDA has decreased
sharply from one year to the next, you should examine the costs that
are affecting that margin. You may find that while most of the cost
components are stable, one particular cost item has sharply
increased. From this analysis, you would be able to conclude which
specific cost explains the significant variation of the EBITDA from
one year to the next.

Interpreting the Expert analysts do not analyze a single P&L—rather, they compare P&L
P&L: What steps statements over a period of three to five years in order to spot overall economic
should I take? performance trends within a company. In order to simplify the process of
comparing data from different years, they typically use a template, which allows
them to put all of the data into a single spreadsheet for easier comparison.

 Step 1: Once the P&L data is transferred into the template, an analyst
starts by looking at the bottom line—net income. As the term “bottom
line” suggests, net income can be found at the bottom of the P&L.
o Examine the net income for the current year—it may help to write
the number down in order to really focus on it.
o This margin allows you to determine whether the company is
generating profits. Is the company making money, which is
reflected by a positive number, or losing money, which is
reflected by a negative number?
o After you have examined the margin in absolute terms—that is,
you have isolated it and looked at it in a non-comparative way,
then analyze it in relative terms—in this case, note what
percentage net income represents of total revenue.
o Next, look at the line item just above net income: corporate tax.
Taxes are the cost component that determines this particular

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margin—net income simply pre-tax earnings, less whatever the

company has had to pay in taxes for a given year. As tax rates
rise and fall, so does net income. (Note, however, that taxes are
a variable that is largely out of a company’s control.)
 If a company is operating at a loss for a given year—if
the company’s net income is negative—it does not have
to pay corporate taxes for that year.
o After you’ve examined the company’s net income for the current
year, examine how this margin has evolved over time. Can you
spot a trend with regard to the company’s profits? Can you
describe the trend? Can you quantify the trend?
o What does your analysis suggest about the company? What
further information do you need to make a thorough diagnosis of
the company’s financial situation?

 Step 2: After you’ve examined the company’s bottom line, it is time to

begin working upward. The next margin, EBT, shows the effects that
financial expenses and extraordinary expenses have on the bottom
line.
o Follow the same process you used to examine net income.
Analyze the current year’s EBT in both absolute and relative
terms.
o Next, examine how this margin has evolved over time. Do you
notice a significant trend? Can you describe the trend? Can you
quantify the trend?
o Examine the cost components that affect this margin—financial
expenses and extraordinary expenses. As these two types of
expenses increase, pre-tax income decreases. Are there
significant changes in these cost components that help explain
the trends you spotted?
o What does your analysis suggest about the company? What
further information do you need?

 Step 3: At this point, you should jump up to the line item total revenue.
o Note the company’s revenue figures for the period under
analysis, in both absolute and relative terms.
o What trend do you notice with regard to the company’s sales?
Can you describe the trend? Can you quantify the trend?
o F you note changes in the company’s total revenue, examine the
line items that impact it. Are sales rising or falling? Have there
been increases or decreases in inventory?
o What do your findings suggest? What other information would
you find helpful at this point?

 Step 4: After you’ve examined the company’s earnings and its revenue, it
is time to study the intermediate steps on the P&L between income and
sales. First, examine the company’s EBIT. This margin shows the impact
depreciation is having on the company’s finances.
o Study the margin for the current year, in both absolute and
relative terms.
o Next, note how the company’s EBIT has grown or declined, in
both relative and absolute terms.
o Do you notice a trend? Describe and try to quantify the trend.
o Study the cost component that determines a company’s EBIT—
depreciation. As depreciation increases, EBIT decreases. How

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are changes in this cost component affecting the company’s

EBIT? Do changes in the cost component explain the trend you
noted?
o What additional information do you need?

 Step 5: Next, examine the company’s EBITDA.

o First, examine the margin for the current year, in both absolute
and relative terms. What does this tell you?
o Determine how the margin has grown or declined, in both relative
and absolute terms.
o Do you notice a trend? Describe and try to quantify the trend.
o After you’ve looked at the margin itself, examine each of the cost
components that impact it.
 First, look at total other operating costs. Examine the
numbers in absolute terms, and then as a percentage of
total revenue. Note, describe, and quantify any trends
you spot. If operating costs are increasing or decreasing,
is there a specific line item that is causing the change?
 Next, examine total selling expenses. Again, analyze
the numbers in both absolute and relative terms, noting
trends. Which line items can you tie to these trends?
 Finally, analyze the company’s cost of goods
produced. Look at this cost category in both absolute
and relative terms, noting any apparent trends. If you do
spot a trend, try to discern which line items are
contributing to it. Has the cost of raw materials increased
or decreased? What about sales staff costs?
o Does analyzing how each of these costs have increased or
decreased explain trends you noted while studying the
company’s EBITDA?

 Step 6: Now that you have analyzed the P&Ls major margins, return to
each cost component you identified as a key factor in explaining the
increase or decrease of each margin.
o Prioritize these cost components in order of importance according
to their impact (positive or negative) on the behavior of the
margins.
o Try to determine if you require further information to better
explain the rise or fall of each major cost component.

 Step 7: After you have recorded and analyzed all of the relevant data
presented in the P&L, create a brief written document explaining your
findings: increases or decreases in sales, the behavior of the margins,
and the cost items that impact the margins. Describe your first
impressions of the problems the company you are studying faces. Note
any additional analysis you think is required.

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Evaluating the As you finish reading the P&L, it can be helpful to start thinking about the
P&L: What steps additional information you may need to perform a more in-depth analysis of
should I take a company’s finances.
next?
 What information, beyond what is found in the P&L, might be helpful in
gaining insight into a company’s financial state? What information do you
lack that would give you as an analyst a more complete picture?
Sometimes, analysts need a more detailed breakdown of specific P&L
items.
o For example, you might need to know which specific items a
company is grouping under the general term “other purchased
goods.” Or you may want to have the sales figures broken down
by product, unit, and price in order to perform a more detailed
analysis. Perhaps the company is losing money through
depreciation of assets, and you need to study what, exactly, is
depreciating. Maybe you have questions about how the
company’s marketing plan is affecting its sales.

 When you determine what you need to know, think about where the
information in question might be found. Is it data that could be gleaned
from a closer look at the company’s other records, or is it information that
can only come from the company’s employees?

 If you decide that you do need to speak to employees, consider which

individuals it would be helpful to interview. Who might be capable of
providing the additional insight you need?