Profit and Loss Statement Part – 1: Type of Income and Expenses in a Business

Just like basic science is of utmost importance to people from every domain, a basic understanding of financial statements is also crucial for each and every person dealing with money. A company's financial statements are like a student’s report card, comprehensively evaluating its overall performance. A student's report card reflects academic strengths, weaknesses, personal growth, behaviour, conduct, etc.; a company's financial statements also encapsulate the multifaceted aspects of a company's financial performance. 

The financial statements comprise of majorly three statements:

• Profit & Loss Statement or Income Statement 
• Balance sheet
• Cash flow statement 

We will dive deep into these statements in the upcoming chapters, laying a strong foundation for fundamental analysis. 

So let’s start with the first financial statement, i.e. Statement of profit & loss. 

Profit & Loss Statement

Whenever you ask a businessman to evaluate a business, the very first question they will ask is, “Tell me how much this company earns”.

Well, asking about a company's profitability is one of the most important parameters to judge whether to invest in a company. This means, unknowingly, the profit and loss statement is the most commonly sought-after financial statement out of the three, and that’s the reason why all Indian companies need to publish a Profit and Loss statement every quarter. In contrast, the Balance Sheet and Cash Flow Statement are published just twice in a year or semi-annually.

We discuss the Profit and Loss statement in this part of the financial statement analysis chapter.

Here, we will discuss 

• The different types of incomes and expenses in a company
• An overview of the P&L account
• A deep dive into the P&L and what to look at to judge the financial health of a company
• How P&L was manipulated by various companies in the past.

Types of Incomes in a Business

The income statement comprises income and expenses.

Income helps you generate money, while expenses are those outlays that help you earn that income.

Broadly classifying, there are two types of income for any company

• Operating Income

The income generated from the sale of goods if the company is a manufacturing/ trading company or the sale of services in case the company is a service provider. Income earned from the principal business operations of a company is referred to as an operating income. Revenue from operations, which is also referred to as the top line of the business, is considered to be an operating income. 

For example, An FMCG company earns revenue from selling FMCG products like soaps, shampoo, groceries, etc. 

• Non-Operating Income

Non-operating income refers to the revenue a business earns from outside its core operational activities. Unlike operating income derived from the principal business operations, non-operating income includes gains and losses from secondary or peripheral activities. It is important to note that Non-operating income can come from various sources and is not directly related to the company's main business operations. 

Types of non-operating income can be:

1. Interest income: You might have heard companies usually pay interest on bank loans. However, a few companies have excess cash and lend to generate extra income, which is shown as part of other incomes. 
2. Dividend income: Companies can also invest in shares of other listed companies and earn dividends from them.
3. Capital gain: When a company sells a non-operating asset such as shares, land pieces, etc., it counts as capital gain. 
4. Sale of scrap: Companies use plants and machinery for their daily business activities, and they, as you all know, have wear and tear and need to be replaced. Therefore, the old machinery is scrapped, and a significant amount can be generated through such sales.

These were some of the incomes that positively affected the net profit. Now, let's get on to knowing about a company's expenses.

Types of Expenses in a Business

In this section, we will learn about the business's expenses in its day-to-day operations.

First, we introduce you to a very important PRINCIPLE of accountancy: the Matching Principle. The principle states that the expenses shown in the profit and loss account should be commensurate to the mentioned incomes.

Let us understand this in a straightforward example.

Let's say you are in the business of making furniture. You got an order to produce 100 tables sold for ₹5,000 each. For this, you purchase 250 wooden plies at ₹1,000 each. Let's assume that this was the only raw material used in manufacturing the tables.

Now, while producing the tables, you could complete the 100 tables order in just 200 wooden plies, and the 50 remained untouched.

So, when you prepare the income statement, you mention the sales to be 100 * 5000 = ₹5,00,000.

On the other hand, the expenses should be 250 * 1000…. But wait, we used just 200 plies, right? Then why 250? Explicitly show just the cost of 200 plies.

Some of you might doubt that we have already purchased 250 and that the cash has gone out of pocket for this. But do understand that the remaining 50 could be returned to the vendor, or since our business is a going concern, these 50 can also be utilised next year.

This is the matching principle of accountancy.

Therefore, the expense mentioned in the profit and loss statement would be 200 * 1000 = ₹2,00,000.

So the profit is 5,00,000-2,00,000 = ₹3,00,000.

The expenses, on the other hand, can be broadly classified into three types:

1. Operating Expenses: The company's expenses in producing goods or services. These are simple ones like raw materials, salaries, electricity, advertisements, etc. 
2. Financing Expenditures: These would be the expenses of using non-owner capital debt. We all know that the cost of debt is called interest. This comes as the line item called financial expenses in the income statement. 
3. Capital Expenses: These are the expenses from purchasing tangible or intangible assets that provide benefits over many years. For example, a textile company purchasing a spinning yarn or an IT company purchasing accounting software that will provide benefits for the next ten years. Now, either these expenses may be directly expensed, i.e. the full amount can be shown in the income statement as an expenditure on the purchase of an asset, or the more conventional route is to capitalise the expense. Capitalisation of expense means moving the asset to the balance sheet asset items and, each year, writing off a part of the same asset called depreciation and amortisation. Depreciation is an income statement line item.

Visualise P&L Statement

	Item	Explanation
Start with	Revenues	Accountant's estimate of revenues/ sales generated by any transactions made by the business during the period
Net out	Operating Expenses + Capital Expenses	Includes all the expenses associated with operations this year, with no benefits spilling into the future
To get	Operating Profit	Profitability of business
Net out	Financial Expenses	Expenses associated with Non-equity capital
To get	Taxable Income	Income to equity investors before taxes
Net out	Taxes	Taxes, based on taxable income
To get	Net Income	Income to equity investors after taxes

 

So this was all about introducing the profit and loss statement and how to visualise it just to start with it. In the next chapter, we will dive deep into each line item of the statement.