What are the basics of Profit and Loss Account (P/L)?
Profit and Loss statement (P/L) statement is a file which contains information on the revenues, costs and profitability of a company for any given time. Financial results are published each quarter by companies and hence we get quarterly P/L statements as well the final audited P/L statement with the annual report.
The below mentioned is the most typical and simple structure of a P/L statement:
|Net Sales (1)
|Direct Costs (2)
|Earnings Before Interest Tax Depreciation and Amortization (EBITDA) (3) = (1) – (2)
|EBITDA Margin (4) = (3)/ (1)
|Depreciation/ Amortization (5)
|Other Income (7)
|Profit Before Tax (8) = (3) – (5) – (6) + (7)
|Tax (9) [@ 30%] = (8) * 30%
|Profit After Tax (PAT) (10) = (8) – (9)
|PAT Margin (11) = (10)/ (1)
What is Net Sales?
This is the income which the company makes by selling its goods and services. All indirect taxes such as Excise Service Tax, Duty, Value Added Tax (VAT) etc. have to be removed from the Gross Sales to get the Net Sales figure as these taxes are collected by the business for the administration and don’t belong to the business. From an investigation viewpoint, it is imperative to comprehend the payment made by diverse segments and markets, the cyclicality of the sales revenues, and the management’s approach to manage any risks to sales growth, such as new products, diversification into new markets, etc. Development in sales must be analyzed to choose the payment of boost in volume and/or amplification in price.
In the illustration above, we have Net Sales of Rs. 100.
What is Direct Costs?
These are costs which can be ascribed directly to business. Illustrations of this category of costs are electrical costs raw material, salary, and others.
Reducing operating costs will explain into higher profitability. Lower the direct costs, higher the operating competence of the company. Costs may be inconsistent, such as raw materials, semi-variable, such as employee costs or fixed, such as plant and machinery.
Companies with high fixed costs can profit from operating control. This is since a boost in sales can be made without taking on extra costs. In times of growing sales such companies profit from better profit margins. The cost make-up of the companies also interpret them to risks when business slow down.
In the above case, we have Direct Costs of Rs. 20.
Earnings before Interest Tax Depreciation and Amortization (EBITDA): This is the disparity between Net Sales and Direct Costs. EBIDTA is a evaluation of the operating competence of the company.
It allows evaluation between companies that may have diverse capital structures, depreciation policies and tax rates. Higher the EBITDA means the company is in good position.
In the above illustration, EBITDA is Rs. 80, which is calculated as (Net Sales) 100 – 20 (Direct Costs).
What is EBITDA Margin?
This is a ratio which calculates the EBITDA as a percentage of Net Sales. Complete numbers make it unfeasible to evaluate two companies; on the other hand, when renewed into percent, assessment can be done easily. Higher the EBITDA Margin, it is good for the company.
In the above illustration, EBITDA Margin is 80% [(EBITDA)*100/ (Net Sales)].
What are Depreciation and Amortization?
Each time a company purchases an asset, it is utilized for a long period of time and for this reason, it does not make common sense to depict whole expenditure at once in the P/L statement.
In the above illustration, to sell goods worth Rs. 100, the company needs a machine which is valued Rs. 100. Currently, if the company were to take a loan of Rs. 100 and purchase the machine and display it as expense in the first year itself, three problems occur:
The company straight away goes into loss as income is Rs. 100 and expenditure would overtake it.
The device would still be accessible for the company to use for future years but it cannot be shown as an asset.
As the company would go into losses, it would not pay tax and that would result into loss of tax revenue for the Govt.
For the reason to avert these irregularity from incident, the expense of buying machine is separated into the approximate life of the asset (machine, in this case) and each year a part of the expense is displayed in the P/L statement and outstanding amount is kept with the company as an asset and is displayed in the Asset portion of the balance sheet.
In our illustration, each year the company would show Rs. 20 as expense and respectively lessen the Asset by that much amount, so that in 5 years the entire machine would be ‘consumed’.
Amortization is the word used for depreciation of intangible assets such as copyrights and brands.
While depreciation or amortization is displayed as an expense in the P/L account, there is no actual cash outflow on account of this expense each year. The expense has been met forthright when the asset is bought.
Deducting Depreciation/ Amortization from EBITDA gives us EBIT.
In the above illustration, Depreciation/Amortization is Rs. 20.
In the above example, EBIT is Rs. 60 is calculated as(EBITDA) 80 – 20 (Depreciation/ Amortization)
What is Interest?
Interest is an expense incurred on loans taken by the business. A change in the interest costs of the company can be accredited to an increase or decrease in the debt outstanding, change in interest rates or currency fluctuations towards foreign currency loans.
In the above illustrations, the company is paying Rs. 20 as interest.
Most of the best companies in India as well as in the world have tremendously low or even no debt. Warren Buffet’s view on debt would help us comprehend with more simplicity, the dangers of high debt:
“Good business or investment choices will in due course produce moderately acceptable economic marks, with no aid from leverage.
It appears to us both foolish and inappropriate to risk what is significant as well as, inevitably, the wellbeing of innocent onlooker such as policyholders and employees. For a few additional takings that are comparatively inconsequential.”
What is Other Income?
This is frequent income from other basis such as rent, interest, dividend, commission etc.
It ought at most excellent be small portion of the Net revenues of the company. When this income is fairly high in evaluation to sales, it permits analysis of the business model of the company.
It is unsurpassed to evaluate other income of the business over last several years and also discover if there were precise activate for high other income in a few kind of businesses.
For instance: In banking, there are times when interest rates are high and owing to which, while on one hand banks keep acceptance deposits, however loan off take is moderately slow.
In similar instances, banks invest in long term G-Secs and advantage from the rise in their prices when consequently interest rates drops. In similar years, other income accounts for a huge component of the total income.
In our illustartion, other income is Rs. 5.