In my career I met my share of managers that clearly did not have much financial base. And let’s be honest, when you made your way as an engineer or salesman, there’s not much reason to be heavily involved in how a finance department does its bookings. But, as with many other subjects, if a manager or indeed any career professional grows in his role and rises to more senior roles, my experience is that at a certain moment you’ll be expected to have some finance acumen. And it does not fall of the sky. So this series of readings will give you a beginners’ understanding of the financials you’ll be in touch with the most. You find the P&L here, and the Cash Flow analysis in a next post (‘How to read any cash flow statement‘). Also see How to read any Balance Sheet.
Please note: I am a financial controller myself. I know this is a very simplified view of a piece of information that is intrinsically difficult. I simplified it for the benefit of the reader and to increase her understanding. My in this blog is to ‘give people an extra edge’ and aims at managers, business men, economics students, MBA aspirants and anything in between. Please also have a look at the schedule included below.
Let’s start with the P&L, i.e. the profit and loss statement of a certain period. As opposed to the Balance Sheet, this is measured over a certain booking period (typically a year, quarter or month).
One of the most important items of this p&l is the sales line, also called Revenue. The sum of the sales appears typically on the first line of the statement, that is why it is also referred to as ‘top line’. In a more extensive view sometimes a differentiation is made between operational revenue, the sales coming out of the company’s normal day to day activity (sometimes called Net Sales if it is corrected for discounts), financial revenue which means revenue out of financial activity and extraordinary revenue which is non recurrent.
The ‘bottom line’ is then the Net Earnings, so the profit that remains after all costs are subtracted from the top line. We’ll detail out the definition of this later on.
As said, in order to get to our profit we need to subtract the costs, and in all financial statements this happens in a consistent, well defined way. It roughly happens from the most concrete to more abstract costs.
The term ‘cogs’ is a much-used term meaning the Cost of Goods Sold. Don’t worry if you are looking at the p&l of a logistics or service company, you’ll find the same here; the costs directly related to producing the goods or services to be sold. So for a manufacturing you’ll see the cost of the raw materials and the manhours spent in production. For service companies, the latter will take in all COGS.
Attached to the cogs, but usually separately mentioned, you’ll find DSC or Direct Sales Cost. This is the costs directly related to sales, not being the COGS. Costs such as logistics, customs, commissions and discounts are booked in here. How to define ‘directly related’? If sales are down to 0, this cost will automatically be zero as well.
Any investments the company has made will be depreciated over a number of years, roughly in line with the economic life time of the asset. The cost of the depreciation, rather than the entire investment, is counted in, although it’s not in line with the real cash spent. Sometimes depreciation is mentioned under COGS.
Opex the next big group of costs a company occurs. It’s short for ‘operational expenditure’ and consists mainly of salary costs (for as far as they don’t belong to manhours in the manufacturing plants, they belong to COGS). A synonym of OPEX is capacity costs.
Usually just after the opex, sometimes mentioned as a part of it, comes the cost for bad debt. If an invoice does not get paid in time, this is where the cost of that will be reported.
These costs mentioned above are all what we call ‘Operational costs’. Other, more minor costs could resort under here but I believe we captured the main ones.
After Operational costs come two other kinds: the financial and extraordinary ones.
Financial costs have a typical, non-operational origin. Interest paid on loans or on overdue A/P, interest earned on a bank account and costs/gains on exchange differences are the main ones. Local law may differ over details how to classify rebates on sales, sometimes the cost of this ends up in this bucket as well. Please note that if the benefits exceed the costs in a given period, this line might well be positive.
The other non-operational costs are called ‘Extra ordinary’ in the accounting system. Sold a fully depreciated asset for a certain price? Had a cost which had nothing to do with your recurring business, say a lost lawsuit? This is the place where you’ll find it.
Please have a look on this in any statement, if there is something substantial in here, it’s well worth investigating as it brings insight in potential risks the company may be facing.
My gosh, here we are finally. Profit is one of those words everybody knows, yet the clear definition of it is only possible after we have gone through the items above. But… we’re not fully there yet. There are many different kinds of profit, the main ones I’ll touch upon here.
Remember the COGS? The revenue minus the COGS will give you gross profit: the most basic kind of profit, the one that will pay your salary costs and all the rest.
Gross profit minus OPEX gives you the ‘Earnings Before Interest and Tax’. Remember the financial costs? We don’t want to contaminate the performance indicator of a company, because that is what profit also is, with this financial mumbo jumbo yet. That’s EBIT.
Is Earnings Before Interest, Tax, Depreciation and Amortization. Hang on, did we not put these two last ones in our costs lines above? Looking at EBITDA means… adding back on the depreciation and amortization again?? Exactly! Remember the remark that depreciation did not really represent a true cash outflow? When building a cash flow statement (please have a look at my article ‘How to read any Cash Flow Statement’), I’ll start from this line to build one.
Often EBITDA is interesting because it’s a better indication of the current performance, filtering out depreciation is often the left over of decisions made a while ago.
Also called net income. This is the end result of all of the above. When subtracting interest and, if appropriate, tax from the EBIT we end up with the net earnings. This is really the money in our pocket. In most cases, the earnings will be divided among the shareholders. It also can be added back into the company, then it is called ‘retained earnings’ in the Balance Sheet.
Here’s an example how it typically works.
Some of these costs are ‘cash costs’, some of them ‘non cash costs’. Eg depreciation, although a cost, does not have an impact on the cash position of the company. This differentiation will prove useful when assembling a cash flow statement.
By the way, if you’re interested, please click here to download my P&L and cashflow schemes.