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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 in order 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 the financial 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 and direct labor used to produce a product.

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, all production 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:

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

To understand how well a company buys and sells inventory or services to make a profit, one must 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 charged against 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 contain several 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 the reported profits.

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

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 additional dollars in the company?

A careful analysis of the financial statements may reveal additional forms of officer compensation 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 of compensation.

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 the early 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 which services 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 reduce reported 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 estate taxes 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 increased significantly, 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 it to the company? If this is the case, could they forego the rent payment, leaving more cash in the company?

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 either reduce or overstate the reported earnings before tax of a company.

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 are controlled is critical to understanding the profit and loss statement.

References

Jacquet, Jay L. and Miller, William C., Jr. The Accounting Cycle: A Practical Guide to Accounting Basics. Crisp Publications, Inc., 1992.

Meigs, Walter B., Johnson, Charles, E. and Meigs, Robert F. Accounting: The Basis for Business Decisions (Fourth Edition). McGraw-Hill Book Company, 1977.

National Development Council. Business Credit Analysis Textbook. New York, New York, 1990.


All educational programs conducted by Ohio State University Extension are available to clientele on a nondiscriminatory basis without regard to race, color, creed, religion, sexual orientation, national origin, gender, age, disability or Vietnam-era veteran status.

Keith L. Smith, Associate Vice President for Ag. Adm. and Director, OSU Extension.

TDD No. 800-589-8292 (Ohio only) or 614-292-6181



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