How to read a company’s Profit & Loss statement | A Beginner’s Guide to Fundamental Analysis
There are plenty of things to learn in the world of investments. It doesn’t necessarily follow that you need to have an accounting or finance background to be good with numbers. The important thing is for you to have a good grasp and understanding. For newbie investors in Singapore, the stock market is an attractive investment ground.
Let’s assume you have interest in investing in stocks. The Singapore stock market is a good option as it is regarded as Asia’s topmost equities market. You have the option to purchase blue-chip stocks or become stockholders of mid-cap and small-cap publicly listed companies according to your sector or industry preference.
The Importance of the Profit & Loss (P&L) Statement
Imagine yourself to be a credit analyst tasked to review the financial standing of a company applying for a corporate loan. One of the financial documents you’d be reviewing is the P&L statement or the ‘income statement.’ You’ll find all the pertinent financial information and activities in the report. A greater part of your recommendation, whether to approve or reject the credit application, will be anchored on the income statement.
Similarly, market analysts and investors would rely on the earnings reports released by the publicly listed companies prior to any buy verdict. If you’re a business owner, it can tell you exactly where your business is headed. Thus, analyzing a P&L report is important in business, investing, and lending activities. Nothing can be handier than a P&L if you want to develop the skill to evaluate a potential stock investment.
As an investor, it is from the P&L that you will see a company’s ability to make profits consistently over a period of time. It is for this reason why an investor should learn how to read financial statements, particularly the P&L.
You will see the dynamics of a company’s operation through the P&L. Over time, you’d realize that a company’s success is not based entirely on cash flows. A company can be profitable without generating substantial cash flows. Inversely, the company may be generating the cash but not raking in the profits.
Reading a Profit & Loss Statement
For the intelligent investor, maximizing returns and mitigating risks are the key objectives. One of the basic tenets before investing in stocks is to analyze the performance of a particular company. You can make an informed and sound investment decision by knowing how to read a company’s P&L.
All P&L’s follow a very simple formula: Revenue less Cost equals Income. It is really not that complicated. Everything else is a matter of breaking down the details by recognizing revenue and cost. Also, the terminologies used may be confusing at the start but once you’ve come to understand them, reading the P&L is no longer difficult.
The Top Line – Revenue
Revenues are always at the top line of the P&L. Revenue can also be referred to as Sales. Revenue or sales refers to the money flowing in from its normal course of operations or the sales generated by the business, plus other cash items derived from non-recurring revenue.
The sources of revenue or sales may vary depending on the nature of the business or industry sector. All sources shall be added to arrive at the ‘Gross’ Revenue or ‘Total’ Sales figures.
The Middle Section – Cost & Expenses
The middle section of the P&L would be the most intricate part. Again, do not be distracted by the terms. Costs are also known as Expenses. Both refer to the funds flowing out or the cash disbursed. This section would include ‘all’ costs and expenses incurred by the company.
All items you will see in this section after the total sales line are costs or expenses divided into several components. Just like revenues, costs and expenses are broken down depending on the items applicable to a specific type of business or industry
You have to familiarize yourself with terms such as Cost of Goods Sold (COGS) or any direct production and services related costs; salaries, wages, & benefits; advertising & marketing expense; equipment & maintenance, among others. These entries constitute all costs and expenses that shall be deducted from the sales or revenue.
The Bottom Line – Profit or Loss
The crucial and final item you’re eager to find out is the Net Profit or Net Income or the more popular financial jargon known as the ‘bottom line.’ However, there’s one more step before you arrive at the bottom line figure.
After you’ve have deducted all cost and expenses in the middle section from the gross profit or total sales, the resulting figure is called the EBITDA or Earnings before Interest, Taxes, Depreciation & Amortization. The EBITDA may be referred to as the Net Operating Income. The interest, taxes, depreciation, and amortization shall then be deducted to arrive at the Net Income.
Using a simple analogy, if the revenue is greater than expenses, the company is making money. Conversely, if revenue is lower than expenses, then the company is losing or “in the red.”
A Simple Exercise
Below is an example of a Profit & Loss report. This is the income statement of Singtel Telecommunications Limited for the financial year ended March 2016. The P&L was taken from its 2016 Annual Report which already shows the consolidated income statement.
- Singtel is a publicly-listed company in Singapore belonging to the telecommunications sector. Take note of the terminologies but do not be confused. Just look for the terms ‘revenue’ and ‘expenses.’
- There is always a clear distinction between revenue and expenses in a P&L to make your analysis easier. Expenses, costs, or other items in parenthesis means these are deductible or subtracted.
- The income statement would always show the preceding year’s P&L to show whether the company performed better or (worse) on a year-to-year basis.
- Be acquainted with the Notes column as these numbers serve a purpose. Read the notes which are attached to the income statement. Each item corresponding to the number is explained in detail. These notes would help you understand what items are included in the particular entry.
- Based on the example, Singtel improved its income year-on-year from S$3,784.50 (in Million) in 2015 to $3.853.30 in 2016. By following the basic formula, revenue generated is greater than the expenses incurred. Thus, Singtel realized profits after all costs of doing business or applicable deductions have been subtracted.
- In case the situation was reversed, the ‘bottom line’ would show a negative value or a number in parenthesis, indicating a loss.
Develop the necessary Financial Acumen
The format of a P&L report is generic. It is well-defined and composed of only two major items – revenue and expenses. You may see various entries with several sub-totals but the approach to reading the P&L is never changing. Just stick to the basic formula.
The P&L basically gives you the overall financial health of a company, whether it’s losing or generating profits. In addition, you can determine whether a company is able to efficiently manage the flow of funds.
Since P&L’s cover a specific period, you can compare the past and present performance of the company (quarter-to-quarter, month-to-month, and year-on-year). Keep a keen eye on the business pattern that will show a flourishing or declining business.
Don’t be intimidated by the numbers but instead, let them serve as your investment guide. Once you’ve developed the analytical skills, you can spot an opportunity or shy away from a losing proposition. Either way, you’ll have a solid basis for making a financial decision.