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How a Profit and Loss Statement Works

How a Profit and Loss Statement Works

A company’s profit and loss statement, which is also commonly referred to as an income statement, is designed to show how a company makes a profit by buying and selling inventory or services. In order to stay in business, a company must conduct their business in a way that results in an overall profit. As compared to a company’s balance sheet, which indicates a company’s financial condition at a specific point in time, it’s profit and loss statement will show the company’s finances over a certain period of time, such as during a specific year, quarter or month. It’s important for companies to keep a close eye on their profit and loss statement, since it is a good indicator of their availability of cash flow. Cash flow is vital to a company’s ability to repay debt, take on addition debt, or reinvest money in itself.

Understanding the Format of a Profit and Loss Statement

A profit and loss statement has categories which are arranged in a certain order. Within each of these categories there is then a listing of expenses and revenues, listed either separately or grouped together. There needs to be a consistency in regards to what expense types are listed under what categories, in order to stay consistent over time. An inconsistency in this regard could be considered to be a red flag in terms of accounting. Although the categories of a profit and loss statement will certainly vary according to the nature of the company’s business, there are certain categories that tend to be typical.

Cost of Goods Sold

One common category is the Cost of Goods Sold, which is often referred simply as “COGS.” This generalized category is used for expenses related to production, which are subtracted from sales. It is calculated for a given time period by adding the purchases of inventory to the beginning inventory, then subtracting the ending inventory. Then, after subtracting the COGS from sales, a company can compute gross profits.

Selling, General and Administrative

The Selling, General and Administrative category, commonly referred to as “SG&A,” contains a company’s variable, fixed and discretionary expenses. These expenses could include the cost of advertising, rent, utilities, insurance, salaries, printing and depreciation. Because this category consists of so many different things, it can sometimes be a bit hard to analyze. In most cases, these expenses have a tendency to remain relatively fixed over a certain time period. However, if sales or production levels change, there can be variations in these expenses. Variable expenses are most likely to be affected by sales levels, since they are generally related to production. These expenses can include the cost of shipping, raw materials and labor. Fixed expenses have a tendency to remain more constant, since they are usually not tied directly to production or sales. These are basic overhead costs, such as insurance or utilities. A company has the most control over discretionary expenses, such as the salaries paid to corporate officers, the level of depreciation, or sometimes even rent, especially if the building is actually owned by the company officers.

Completing the Calculations

Once the expenses and revenues of a company are calculated for a certain time period, it’s a relatively simple task to calculate the overall profit or loss. This calculation is performed by subtracting the expenses from the revenues, thus ending up with the profits for that time period.