Learn Balance Sheet Before Profit and Loss Statement
Welcome back to our Accounting Tutorial Blog Post. Take a look back to 6 Steps To Learn Accounting For Business Professionals to know the steps you should take to learn Financial Accounting. Today we are going to learn about Profit and Loss Statement. We made this blog post as simple as possible for you to understand the concept of Profit and Loss Statement, so make sure you read this blog post carefully before you even learn more about Profit and Loss Statement. If you have not read our previous blog post 9 Tips To Read Balance Sheet, stop right here and learn about Balance Sheet before you learn reading Profit and Loss Statement. It is important to understand the fundamental concept of Balance Sheet before you move on to learn reading Profit and Loss Statement.
What Is Profit and Loss Statement?
Profit and Loss Statement is one of the financial statements that companies are required to disclose to describe the performance of the business during each fiscal period. It is used to explain how much revenue and profit that you made. It also covers the type of cost that your company spent on business activities. Profit and Loss Statement will provide the following financial information to stakeholders.
– Shows your business performance during the fiscal year.
– Increases and decreases detail of Earning Surplus (Accumulated Earnings)
What is Revenue, Expense and Profit
The first thing you need to understand is the Profit and Loss Statement structure. As you learned about Balance sheet, it only describes the total amount of accumulated profit which turns out to be the increase of Assets. You will not be able to identify how much you sold and the cost associated with your sales. Profit and Loss Statement covers how you made profit based on your business activities. Therefore it requires describing the following structure.
Revenue – Expense = Profit
If you take a look at the sample of Profit and Loss Statement, you can understand that it shows the details of income and the cost to make a profit. Revenue is the increase factor of Earning Surplus and Expense is the decrease factor of Earning Surplus.
Profit and Loss Statement and Income Statement
Profit and Loss Statement and Income Statement is the same financial report. In the Americas, it is called Income Statement whereas Great Britain it is called Profit and Loss Statement. In this blog post, we will simply standardise using Profit and Loss Statement.
3 Steps of Reading Profit and Loss Statement
So now let’s learn about the 3 steps of reading Profit and Loss Statement. When you read Profit and Loss Statement, it is important to understand the steps to understand the concept of Revenue, Expense and Profit.
STEP 1: Learn 3 Types of Revenues
As you understand the basic concept of Profit and Loss Statement, now you need to know the three types of Revenues. Remember that Revenues are categorised to describe the details of how you earned income in your business.
1. Revenue from primary business activities
This is the main income in your business. You sell products or service to customers, and this is where you will book your sales. For example, manufacturers will purchase material and manufacture products and sell them to customers. Retailers will purchase merchandise and sell merchandise using their distribution channel. Consultants will perform consulting service to clients and gain revenue as consulting fees. These are operating revenues you gain from primary business activities. If you don’ know about the company and you are reading Profit and Loss Statement, you would want to perceive the revenue from business operations and other activities such as selling your fixed assets or financial interests.
2. Revenue from secondary business activities
These are non-operating revenues which you earned besides your primary business activities. If a manufacturing company receives revenue based on financial interest or receive a dividend from securities, then this will be treated as non-operating revenue. Secondary business activities will regularly occur throughout the fiscal period. This means that it is not a temporary income.
3. Extraordinary Gains
Extraordinary Gains are temporary income besides the primary business activities. The difference between Revenues from the secondary business activity is whether the income is constant or temporary. For example, selling fixed assets such as building, cars, equipment is temporary because you don’t continually sell these fixed assets.
STEP2: Learn 3 Types of Expense
Now that you know the different types of Revenues let’s move on to Expense. The categorisation of Expense is same as Revenue. There is some country specific classification which drills down to analyse the profit in detail. However, as we are learning the fundamentals, we will focus on the three primary categorisations before you learn other categorisations.
1. Expense from Primary Business Activities
This is the corresponding Expense occurred to Revenue from primary business activities. When you are selling products or services, you need to consider the cost of goods sold. If you are a retailer, then the purchase of merchandise is the cost that you need to book as the cost of goods sold. For manufacturing companies, purchased materials, direct labour and depreciation cost of machines and equipment will be the cost of goods sold of the finished products. It is important to visualise the cost of business operations so that you can compare with the operating income to know how much you earned a profit by your business operation.
2. Expense from Secondary Business Activities
Expense from secondary business activities is the Non-Operating loss which is the Expense besides your primary business operations. Examples of Non-Operating Expense are the loss from foreign exchange rates and cost of obsolete inventories.
3. Extraordinary Loss
Extraordinary Loss is a temporary loss which is not related to operating Expense. When you sell your fixed assets below book value, then you will book loss on sales of fixed assets as an Extraordinary loss.
STEP3: Learn 3 Basic Profit (Income)
1. Gross Profit
Gross profit is the profit your company made by deducting the associated cost of making and selling products or delivering services. It is used to analyse the amount of profit made based by deducting Cost of Goods Sold which is the direct cost of goods. Gross Profit is used to assess company’s performance based on the actual cost required to sell, make or deliver your product or service.
Calculation of Gross Profit
Revenue – Cost of Goods Sold
2. Operating Income
Operating income is the profit made based on your company’s business operations. Gross Profit only covers the Cost of Goods Sold, but Operating Income also deducts Operating Expense. Examples of Operating Expense are salaries, marketing cost, depreciation cost of fixed assets, insurance and transportation cost. We use Operating Income to analyse how much profit you have earned based on your primary business activities.
Calculation of Operating Income
Revenue – Cost of Goods Sold – Operating Expense
3. Net Profit
Net profit is the profit your company makes after deducting non-operating expenses and extraordinary loss. It also considers profit after tax. However, in the Profit Loss Statement, there are Net Profit before tax and after tax deduction. Every company must follow the statutory requirement of tax in each country. To identify the tax difference among countries, it is better to calculate Net Profit before tax and after tax deduction. Net Profit is the overall profit you made during your financial period. Therefore Net Profit will transform as Earning Surplus to show as part of your Shareholders Equity.
Calculation of Net Income
Revenue – Cost Of Goods Sold – Operating Expense -Non-Operating Expense (Includes Estraordinary Loss)
Remember The Objective of Profit and Loss Statement
You must always come back to the fundamental objective of why we need Profit and Loss Statement. There are other concept and formula you need to learn to read Profit and Loss Statement. We did not cover the Chart of Accounts of Revenue, Expense and single-step multiple-step incomestatement . However, we believe that this concept is the starting point of reading Profit and Loss Statement. If your not confident to explain the concept we have provided today, go through the contents again. The fundamental objective is to disclose business performance within the financial period. You want to visualise the profit by business operation and non-business operations. Net Profit is the final profit you’ve earned based on the Accounting principles. Make sure you understand the basics and practice to explain this concept to others.