Tuesday, July 04, 2006

The profit and loss (P & L) statement or income statement

The Profit and Loss Statement is the second instalment of the three financial statements in annual reports and is the most frequently looked at. It describes how the company has done over the past period in terms of sales and profits on paper. The P & L begins with Sales or Revenue at the top and is followed by all sorts of costs until we arrive at net profit. The following is usually how the P & L is arranged:

1) Sales or Revenue
2) Cost of Goods Sold (COGS)
3) Selling, General and Adminstrative Expenses (SG&A)
4) Operating Income or Operating Profit
5) Interest Expense or Income
6) Recurring Income or Recurring Profit
7) Extraordinary Gain or Loss
8) Profit before Tax
9) Net Profit

The most important no. to look at is 4) Operating Profit (or EBIT: Earnings before interest and tax). This no. is basically the profit that the firm has booked after it has subtracted all relevant costs that are incurred in doing its business. Below operating profit, no.s are subjected to very serious manipulation and hence become seriously unreliable. (That doesn't mean that the operating profit cannot be manipulated though, in fact, everything from Sales to Net Profit can be manipulated, that is why integrity of management is so important.)

In recent years (esp so during the dot.com boom), a lot of listed co.s could not even generate a positive OP (i.e. their core business was losing money after factoring in all relevant operational costs). Hence analysts invented another no. called EBITDA which stands for Earnings before whatever it takes to make it a positive number. Well actually it's "Earnings before Interest, Tax, Depreciation and Amortization". It means that if we do not take into account depreciation cost, the co. may be making money.

To put it in another light, say you bought an ice-cream machine that cost $200, you use it to make ice-cream selling for $1 and you declare that you made $200 after selling 200 ice-creams. The cost of the ice-cream machine? Doesn't matter, as long as EBITDA is concerned. Depreciation cost for the ice-cream machine is not a cost under the definition of EBITDA.

See also COGS and SG&A
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