You need not be a finance whiz kid to understand and play with financial concepts. Let me prove that to you by making you understand a Financial Statement of a company.

Understanding the basics of financial statements for beginners – Part 1

Suppose you have a company which manufactures chocolates, which sell across India. Let’s assume each chocolate sells for Rs.10 on average and you sell 10 Crores chocolates every year. The money that you get by selling your chocolates to retailers (Average price of Rs.10 * Total 10 Crores Chocolates sold = Rs.100 Crores) can be called Sales or Revenues.

You obviously have to pay the government taxes on your Revenues. So, your remaining Revenues after subtracting these Sales Taxes is called Net Revenue. Easy till here, right?

Revenues – Taxes = Net Revenues

Now, you would have had to buy raw materials like sugar, cocoa beans, milk powder, nuts etc., for making your finished product (chocolate). They would have costed you a definite amount. This cost is called Cost of Goods Sold or COGS, and you will subtract it from Net Revenues to get the Profit.

This Profit is called Gross Profit.

Net Revenues – Cost of Goods Sold = Gross ProfitWow, you have learned how to calculate Gross Profit already!

Now, in your chocolate factory, you would have had managers, workers, supervisors, admin team, finance team, etc., to make the best chocolate and keep the factory functioning. The salaries you pay to them can be called Human Resource Expenses or HR Expenses.

To run a factory, you need to spend a lot of money, for fuel, power, water, rent or lease etc. All these costs can be together called Operational Expenses.

Again, your factory will be in a particular location on the outskirts of a city or town because such large factories cannot be inside a city. Let’s assume it is in a small town in Himachal Pradesh. The delicious chocolates you make have to be transported by trucks to each city in India, where people would want to eat them. So, you transport to depots outside those cities by large trucks. From these depots, they will be transported to small distributors and retailers in the nearby areas by small trucks and tempos. The cost incurred can be called Transportation or Logistics Expenses.

You will also need to pay a small amount to retailers as their profit for keeping and selling your chocolates to their customers. Similar other commissions and costs incurred in selling your goods are clubbed together in Sales & Distribution (S&D) Expenses.

There can be other General & Administration (G&A) Expenses in running such a big business.

To generate demand for your chocolates, you will advertise in different channels, like TV, radio, billboards, online, newspapers etc. The cost incurred in all this is called Marketing Expenses.

By subtracting these and other such expenses which help you make chocolates, from Gross Profit you get Operational Profit or EBITDA (Earnings before Interest, Tax, Depreciation and Amortization – more about it later).

Hence, Operational Profit = Gross Profit – HR Expenses – Operational Expenses – Logistics Expenses – S&D Expenses – G&A Expenses – Marketing Expenses

This is the actual profit you make from running your business operations.

This does not seem as tough as it is made out to be. It’s just basic addition and subtraction!

You might have taken loans or debt to run your business; hence, you have to pay Interest (I) on that loan, correct?

Also, the value of the machines in your factory and the other equipment, your trademarks, patents etc., is depreciating every year since it is in use. This is called Depreciation & Amortization (D&A).

After removing Interest and Depreciation from Operational Profit, you get Profit before Tax (PBT). In other words, you removed I and D&A from EBITDA, leaving EBT or Earnings before Tax. You are on the right track, Earnings and Profits are one and the same thing.

In short, PBT = Operational Profit – Interest – Depreciation & Amortization

As you have made a profit, you will have to pay tax to the government on it. After subtracting this tax, you get the final Profit after Tax (PAT).

Or, PAT = PBT – Taxes

All these calculations in a tabular form are collectively called Profit & Loss statement or abbreviated as P&L.

So, your P&L starts from Revenues at the top and ends at Profit or Loss at its bottom.

Summing Up

Can you believe it, in just 5 minutes, you have understood the basics of a P&L. Next time, we will give financial statement on Balance Sheet a go. Meanwhile, a run through a few P&Ls will help deepen your understanding, like this one:

Related Articles: