Profit and Loss Account - Basic step by step explanation

Another important financial statement used in the corporate world in the 'Profit and loss' statement. This is one the final account which is used for many financial analysis as well as to know the profits posted by the firm in the whole financial year.

The profit and loss account, also known and 'Income Statement' or 'Income and Expenditure Statement' is written with a step by step reduction of different expenses involved in the organization.

The firm is able to find out the exact computation of profitability at each step and also arrive at a analysis of where is the expenditure more and potential area for cutting cost and thereby improving profits.

The steps involved in the profit and loss account are -

SALES
(-)COGS (Cost of Goods Sold)
GROSS PROFIT
(-)Operating Expenses
(-)Depreciation
OPERATING PROFIT
(-)Non operating Expense
PBIT
(-)Interest
PBT
(-)Taxes
PAT

This is typically called the 'vertical' or 'corporate' format of profit and loss account. In this section, typically the 'final' profit computation from Sales is done with a step-by-step computation. Different types of expenses are getting deducted from the sales.

Typically for any organization, the calculations would start with the 'sales' number or the 'gross revenue'.
From Sales, firstly the costs which are directly proportional to the selling of the goods is deducted. This is typically called "Cost of Goods Sold" (COGS).
COGS included all expenses which are 'directly' responsible for the selling of the goods. This typically includes cost of material, transport, labour, etc which directly contribute to the sales.

After deducting COGS from Sales, we arrive at 'Gross Profit'. Hence

SALES - COGS = GROSS PROFIT

From gross profit, when the operating expenses and depreciation is deducted, we arrive at 'operating profit'. The operating expenses include all expenses which are indirectly related to sales and are responsible for the operations of the firm.
These include administration costs, electricity, telephone, etc. Hence,
GROSS PROFIT - OPERATING EXPENSES & DEPRECIATION 
= OPERATING PROFIT

From operating profit, the next component which is deducted is 'non operating expenditure'. Non operating expenditures are the expenses which are not a part of operations, but are an expense which need to be done. A simple example is insurance. The insurance expenses are not a part of operating activites of a business, but are a expense. Hence
OPERATING PROFIT -  NON OPERATING EXPENSES 
= PBIT (profit before interest and taxes)

PBIT is the first component of calculation of profit, after paying the organization expenses. This is the first profit, before you pay out the interest and taxes.

From PBIT now the 'interest' component is deducted. This is the deduction of the interest payable for the long term loan that has been raised by the company. This is the loan portion in balance sheet called 'debt'. For every loan raised, there is a interest that in being charged, and we need to pay the interest. This deduction gives the profit which is profit before taxes. Hence,
PBIT - Interest   = PBT

Profit before Taxes is the profit which is computed before paying 'taxes'. From profit before taxes the taxes need to be deducted from PBT. The tax component includes the taxes which are liable to be paid by the organization. After paying the taxes, the remaing profit is PAT 'profit after tax'. Hence
PBT - Tax  =  PAT

PAT / 'profit after tax' / 'net income' is the final profit that remains with the firm after paying all direct, indirect and all other expenses of the firm. Hence this is the final profit can be said, what a firm gets.

From PAT, the dividends are being paid to shareholders of the firm. The shareholders are the people who have invested money in the firm by purchasing their shares. This money is called the equity of the firm.

This is the step-by-step explanation of the profit & loss account which is one of the most crucial statement which determines the profitability of the firm in the current accounting year. This statement is ideally calculated on the last day of the financial year.

Significance of Balance Sheet

There is a popular myth that there a lot of basic concepts required to be understood and analyzed before analyzing the balance sheet. The truth is that balance sheet is derived from the basic working of the funds flowing the organization.

When a balance sheet is formed, it basically depicts how the money has come in the organization, what all are the aspects where the money is used, and how much money should be paid out too.
The company basically looks at the overall status and the position of its working year after year by having a look at the balance sheet.

As we saw, the balance sheet is basically divided in 'Liabilities' and 'Assets'.
The 'Liabilities' now can be segregated in two parts - Long term and short term.

The long term liabilities are the components from the area, from which the company has raised money for its operations. Hence it is called "Sources of funds". These sources of funds have two components "Equity" and "Debt".
Just to have a overall feel, "Equity" is the component wherein the company has raised money by issuing shares to the public. "Debt" is the component wherein the company has taken a loan or borrowed money for operations.

The short term liability by-and-large looks at the 'Current Liabilities'. Wherein there are current payments deliverable like creditors, bills payable, short term loans, etc.



Now at the Assets side, the Asset part is divided in 'Long Term Assets' and 'Short Term Assets'.

The 'Long Term Assets' comprise of Fixed Assets and Investments. These are the components which are directly or indirectly responsible for generating revenue and sales of the firm.

The 'Short Term Assets' are mostly the Currents Assets wherein the assets which are in hand or going to receive within one financial year.


Now the very basic analysis or significance of the balance sheet is -

The LONG TERM ASSETS should be able to suffice the LONG TERM LIABILITIES, and
The SHORT TERM ASSETS should be able to suffice the SHORT TERM LIABILITIES.

Hence this means that the company's operations are so strong that the current operation payables can be paid from the operating activity itself.
And the long term assets are so strong that they sufficient enough that the firm can payoff their long term liabilities.