2. Reading the profit and loss account

Where the balance sheet is a photograph, the income statement is a film. It shows what came in over a full year, which costs were set against it and what was left at the bottom line. You will also come across it as the profit and loss account, or the P&L for short. In a monthly report you usually see a condensed version of exactly this overview.

The steps from turnover to net profit

The logic is simple: revenue minus costs is profit. The art is in the order. The costs are deducted step by step, and after each step there is an intermediate result that tells you something different.

At the top is the net turnover: everything you have invoiced to customers during the year, excluding VAT and after deducting discounts and returns. Note that word invoiced, because that is something different from received. An invoice that goes out in December counts towards that year, even if the customer does not pay until February.

Below that is the cost of sales: everything you had to buy or hire in directly for what you sold. In a trading company that is the purchase price of the goods resold; in a service provider it is the hours of the people who did the work. Deduct that and you are left with the gross profit left.

Below that come the operating costs: everything you spend to keep the place running. What is left after that is the operating profit, in English EBIT. That figure shows how well the operation itself is running, regardless of how the company is financed and regardless of tax. If you want to compare two companies, one of which has borrowed heavily and the other not, then the operating profit is a fairer measure than the net profit.

There are two more items below the operating profit. First the interest that you pay on loans, minus the interest you receive yourself. That brings you to the result before tax. From that, the corporation tax off it, and then at the bottom you are left with the net profit.

The four main cost groups

Below gross profit you will almost always find the same four groups. Staff costs: salaries, social security contributions, pension contributions, training and temporary staff. For most organisations this is by far the largest item. Premises costs: rent, energy, cleaning, maintenance. Depreciation: the annual depreciation of machinery, fixtures and vehicles. And other operating expenses: marketing, IT, insurance, accountant, travel and everything else.

Depreciation is a special case, and it is where many people get stuck. It is a cost item where no money leaves the business. You paid for the machine three years ago, and you now spread that outlay across the years in which you use it. As a result, a company can show a decent profit and be short of cash at the same time, or the other way round.

Fixed or variable, direct or indirect

To understand a profit and loss account, it helps to classify costs in two ways. Those two classifications are independent of each other and answer a different question.

The first question is: does this cost item move with revenue? Variable costs do. If you sell twice as much, you also purchase roughly twice as much material. Fixed costs do not, at least not in the short term: the rent on your premises is the same whether you sell a hundred or a thousand units. This distinction determines how vulnerable an organisation is if turnover disappoints. High fixed costs mean a high threshold before you have covered your costs.

The second question is: can you allocate these costs to a single product, project or customer? Direct costs you can: the materials for a specific order, the engineer's hours on a job. Indirect costs you cannot: reception, the IT department, the board. They are necessary, but they do not belong to a single sale. To find out what a product or department actually yields, they are usually allocated using an allocation key, for example by revenue or by the number of hours worked. Always ask which key has been used, because it determines whether your department comes out looking good or bad.

Margins tell you more than amounts

A margin shows what is left of every euro of turnover, and there are three levels. The gross margin is the gross profit divided by turnover, and says something about your purchasing power and your pricing. The contribution margin deducts all variable costs from turnover and shows what contributes to covering your fixed costs. The net margin is the net profit divided by turnover, so after everything: after costs, after interest and after tax.

A margin only means something in comparison. A net margin of 3 per cent is dire for a software company and perfectly normal for a building contractor or a supermarket. So compare with last year and with your own sector, never with a percentage you happened to pick up somewhere.

The bridge back to the balance sheet

The balance sheet and the income statement are not separate documents. The clearest link runs through the net profit: whatever is left at the bottom and is not paid out as dividend goes to the equity on the balance sheet. A profitable year makes the organisation wealthier, a loss-making year eats into equity.

There are more bridges. The depreciation in the profit and loss account belongs to the fixed assets on the balance sheet: a machine costing 100,000 euros with a life of five years appears on the balance sheet at 80,000 euros after the first year and produces 20,000 euros of costs in the profit and loss account. The stock on the balance sheet changes through purchases and sales, and the part sold turns up as cost of sales. And the interest charges in the profit and loss account are a direct consequence of the debt capital on the balance sheet. More debt means more interest.

Summary

• The profit and loss account works step by step: revenue, less cost of sales gives gross profit, less operating costs gives operating profit, less interest and tax gives net profit.
• Revenue is about invoicing, not about receiving payment. That difference is the heart of the distinction with cash flow.
• The four main cost groups are staff, premises, depreciation and other operating costs.
• Depreciation is a cost without any money leaving the business, and that is why profit can be something other than money in the bank.
• Variable costs move with revenue, fixed costs do not. Direct costs can be assigned to a product or project, indirect costs cannot.
• Gross margin, contribution margin and net margin show at three levels what is left of every euro of turnover. Compare them with last year and with your sector.
• The profit that stays in the business increases the equity on the balance sheet. That is how the two statements hang together.