One of the main financial statements you can use to analyze a business is the Profit and Loss statement (aka the income statement, the P&L, or the statement of financial results).

What does it do?

The P&L measures the revenues, costs and expenses of a business over a period of time. You start at the top with revenue (or sales) and end at the bottom with showing either a profit or a loss (hence the “P&L”  because “PorL” just sounds weird ). It is most often used in concert with a balance sheet and a cash flow statement to show a more comprehensive view of the financial performance of the business. These form the “big 3” financial statements.

What does it mean?

The P&L shows a company’s ability(or inability) to generate profit through a combination of sales activity and costs to the business. Comparing P&L’s over time can show the changes in sales, operating expenses (like salaries), capital expenses (like equipment purchases) and profit over time to make for a more meaningful understanding of business trends.

The who’s who of a P&L…

Revenue, sometimes referred to as the “top line” because it is normally the top line of the P&L, is how much the company sold in a given period.

Cost of goods sold (COGS) is often the next section, and represents the costs directly related to the production of the goods being sold. Examples can include materials, labor, or shipping. A quick test on if an expense may be in COGS instead of in operating expenses is to ask, “would this cost exist if the company didn’t have sales?”

If you subtract COGS from revenue, that gives you the company’s gross profit.

Operating expenses, sometimes called “overhead”, are the expenses not tied directly to sales. These include things like payroll, rent, marketing, and insurance.

When you get past these expenses, many times you will see the odd acronym – EBITDA. This stands for earnings before interest, taxes, depreciation, and amortization.  It is basically net income with taxes, depreciation and amortization added back. It is a helpful way of looking at operating performance because it removes the extraneous influence of accounting and financials deductions.

While a useful metric, don’t rely on EBITDA as a good measure of how much cash a company may have. Like your first budget, it excludes some big items that need to be considered in determining a business’s free cash…but that is a topic for another day! For now, find a few P&L’s to review and compare. You’ll soon realize the power you have to dig a little deeper in understanding how your prospective investments are performing.