Profit and Loss Statement Part – 2: Components and Examples

Deep Dive into P&L Statement

Since you all have already seen what a P&L statement looks like, it's time to hit the bullseye. Let us learn different line items in a Profit and Loss Statement using the example of XYZ Ltd. 

The first item is always going to be “Revenue from operations.”

As you know, Revenue represents the total amount of money generated from selling goods or services. The revenue can be sales revenue, service revenue, and any other income directly related to the primary operations of the business, like the money earned from selling products like shampoo or providing services like consulting.

No matter how much you concentrate on profitability, concentrating on sales growth is equally important.

Other Income

This line item includes income earned from sources other than the primary operations of the business. It can include rental income, interest income, gains from the sale of assets, or any other non-operating income. 

Please note that we get total income when we combine revenue from operations and other income. 

Now, let's move on to the next line item.

Cost of Goods Sold (COGS)

COGS includes the direct costs of producing or acquiring the goods being sold. This includes expenses such as raw materials, direct labour, manufacturing overhead, and other costs directly attributable to the production process.

COGS in the income statement is calculated by adding the cost of materials consumed, purchase of stock-on trade, and changes in inventories of finished goods, stock-in-trade, and work-in-progress.

Employee Benefit Expenses

These are the costs, such as salary paid to employees, their conveyance cost, bonuses, gratuities, etc., that a company makes to retain its employees. ESOP [Employee Stock Options Plan] expenses are also part of Employee Benefit expenses. Now, what are ESOP expenses? Let us come to this.

Lately, many companies, to retain employees, provide them with stocks as a form of ESOPs. This is a company-specific scheme wherein the employees are offered the company’s stocks at a significant discount, sometimes as high as 90% discount; however, they are saleable only when the employee completes specific years in service. 

Finance Cost

Finance cost is a critical component in a company's profit and loss statement. It represents the cost of borrowing funds or the return on debt capital the business employs. Finance costs are incurred when a company borrows money to finance its operations, investments, or other financial obligations.

Depreciation & Amortisation

Depreciation is a part of the company's non-cash expense. The asset’s cost price will be expensed each year till the average useful life of an asset. It does not necessarily mean the asset becomes obsolete at the end of the depreciating life. This is just an accounting rule to indicate the expense incurred. 

Depreciation of intangible assets is referred to as amortisation. Intangible assets are non-physical assets that lack a physical existence but have value, such as patents, trademarks, copyrights, goodwill, and certain types of software. The amortisation process, like depreciation, allocates these intangible assets' costs over their estimated useful life.

For example, consider an IT company purchasing software for ₹10 lakhs that will benefit the company for the next ten years. The software is an intangible asset because it has no physical presence or cannot be touched or felt. Now, instead of expensing the entire ₹ 10 lakh in the profit and loss statement, software cost is amortised over its serviceable life. Thus, every year, ₹1 lakh will be treated as an amortisation expense in the profit and loss statement. 

Remember, Depreciation & amortisation is not an actual cash outflow. The outflow has already happened in the past in bulk, and depreciation is just accounting for it slowly and steadily year after year.

Other Expenses

Other expenses are costs that are not directly related to the business's core operations. They can include losses from the sale of assets, foreign exchange losses, legal settlements, or any other non-operating expenses.

Profit Before Tax (PBT)

It represents the profit generated by the business before considering income tax. It is calculated by subtracting all the expenses from the total income. 

Income Tax Expense

Just like you have to pay taxes on your personal income, companies must also pay taxes on the income they have generated in a financial year. Income tax expense represents the tax liability incurred on the profit generated by the business. 

Profit After Tax (PAT)

PAT is calculated by subtracting the income tax expense from the profit before tax. It represents the final profit generated by the business after considering income tax.

That wraps up our overview of the line items in a profit and loss statement prepared per INDAS. I hope you all have a better understanding now. 

However, is the net profit enough to analyse a company? Well, not really; analysts use various other types of profitability measures to evaluate the full business potential. Let’s discuss some of those measures. 

Gross Profit

Gross profit is obtained by subtracting the COGS from the revenue. It represents the profit generated from the business's core operations before considering operating expenses.

Mr. Warren Buffet considers gross profit a crucial indicator of a company's pricing power.

Now, what is pricing power? See, every company listed in the stock markets is here to earn money and charge you more and more. But is it possible? We all love Frooti and know it's suitable for the price point of ₹10. But what if tomorrow, the sellers of Frooti decide to raise the price to ₹20? Would you still buy it? Well, some of us would, but there will be an impact on the sales. However, if the company can do that without much impact on sales, it is said to possess pricing power. And gross profit is here to show us that.

So, next time you track a company's profitability, start by tracking the gross profit and the other kinds of profits, which we will discuss further. 

EBITDA (Earnings Before Interest, Tax & Depreciation)

EBITDA is obtained by subtracting the operating expenses from the gross profit. Some refer to EBITDA as operating profit. It reflects the profitability of the business's core operations before considering non-operating expenses. Why is EBITDA important for a business?

EBITDA helps us assess a company's performance in its core business activities, excluding non-operating factors.

EBIT (Earnings Before Interest & Tax)

Subtract depreciation and amortisation from EBITDA to get EBIT or operating profit.

Think this way: your operating expenses are all those you incur as part of doing business. So these are power, employee, refreshment, and travelling costs. You include all these rights. But don’t you notice some wear or tear for each production unit? Let it be small, but it is happening to the machinery, too. That is a cost. And that is depreciation. It might not show you today, but someday, it will show up, right? You have to replace the machinery. Therefore, always treat depreciation as an operating expense.

Notes to Accounts

As they say, “The devil lies in the details.” In the case of P&L, the devil lies in the notes to accounts. What you see in P&L statements is just the summary of all the incomes and expenses accrued during the year. However, one has to see the minute details to get an accurate picture of the company.

Notes to accounts are in all the financial statements and tell us what a particular line item comprises. This is because, per the accounting standards, most of the line items in the P&L statement are standardised. But various line items need more scrutiny. 

Difference between Standalone and Consolidated Financial Statements

Every company has a standalone financial statement. A standalone statement will keep the record of the company's accounts, ignoring any subsidiary or joint ventures the company may have, while the consolidated entity will show the entire picture.

For example, Reliance’s standalone business only comprises oil extraction services, while all the other businesses, like Retail, Jio, Media, etc., are subsidiaries. Hence, the standalone statements of reliance will show the performance of just the oil business. In contrast, the consolidated statements will provide an accurate picture of the company, showing the performance of standalone businesses + subsidiaries, and joint ventures.

Now that you have understood the difference between standalone and consolidated statements, another critical aspect of income statements is the accounting of ownership in other businesses.

There may be three types of ownership:

1. Investment: A company may invest in the equity share capital of other listed entities. The share is non-controlling and is less than 20%. This is a normal investment with no motive for controlling the company; hence, the financials are not consolidated in the company’s financial statements.
2. Associate: This is also a non-controlling stake; however, the stake is significant enough to exercise certain influence. The stake has to be between 20-50% to be an associate company. The profit/ loss from the associate company is shown as a separate line item in the profit and loss account.
3. Subsidiary: An investment is categorised as a subsidiary with more than 50% ownership. If the company has a 100% subsidiary, every line item, like the subsidiary's revenue, costs, etc., will be added to the standalone figures to get a consolidated statement. However, if it is lower than 100%, say 60%, you’ll be shocked; the accounting standards suggest consolidating them as a 100% subsidiary, too. However, there will be an adjustment for this, called minority interest. This will reduce the share of profit, in this case, 40% from the consolidated profit, or will increase the consolidated profit by the share of loss, i.e. 40% in case the same is not owned by the company.

Manipulation in Profit and Loss Statement

Now that you have understood how to read the P&L statement be cautious that there are always some loopholes in which untrustworthy management can manipulate it to show you what you want to see.

There have been numerous instances of manipulation in the P&L statement. It is the easiest of the three statements to manipulate simply because it depends on the accrual accounting concept.

To give you a recap, there are two ways in which a transaction can be accounted for in a financial statement. One is the Cash Basis, the regular cash and carry accounting. Suppose a business sells five soap pieces and gets only money for four soaps. Here, it would show just four as sales.

The other one, and the most commonly used one, is the Accrual Basis of Accounting. Here, the business would regard the entire five as sales irrespective of whether you have received cash.

As you guessed, sales are the most manipulative object in a P&L statement. This is a widely known practice of managing invoices to show better sales figures than the actual ones.

Extraordinary Profits or Loss

This is another area that requires the attention of the investors. As you might recall, exceptional profits or losses are those kinds of profits that are not due to the company's daily business operations but are one-time.

Relevance of Profit and Loss Statement

This gets us to the relevance of the profit and loss statement. Knowing about a company's profitability can help you instantly judge whether the company is a good investment. Typically, a stable and well-run business will be profitable, and why shouldn’t it be the case? This is what the business is all about, right?

Then, is the profit and loss statement not crucial for a loss-making company? Of course, it is. The profit and loss statement shows the company's revenue or sales numbers. A loss-making company is only investable if it can grow its sales sequentially, i.e., quarter or year on year.

Let’s look at ABC Ltd, a new-age technology industry.

Year	Net Loss [In ₹ Crores]
2018	-123
2019	-136
2020	-145
2021	-54
2022	-200
2023	-240

Look at how the company is continuously making losses. However, is that it? Should we simply ignore this company because it's a loss-making business? Why don't we have a look at the sales figures too?

Year	Sales	YoY growth %
2018	1000	-
2019	1220	22.00%
2020	1650	35.25%
2021	2340	41.82%
2022	3560	52.14%
2023	5980	67.98%

This is where things get interesting. The company's sales are continuously growing at a very fast pace. This is the case with most new-age start-ups investing upfront to capture the market, compromising profitability for initial years of exponential growth. 

The profit and loss statement also includes a company's expenses. I am sure you know that the company generates a loss when the expenses are more than the revenues. What if the expenses as a proportion of sales decrease sequentially? Does that mean something? Yes! This means the company is losing now, but slowly, as the sales grow and expenses reduce, it will become profitable.

Did you see how understanding all the financial statements is very important for you to prevent burning your hands? 

In the next chapter, we will dive deep into the balance sheet.