Everyone Loves P&L
Understand P&L to understand company finance.
KEY Premise
Company profit and loss statement directly connects to its business operations. The business operations can be understood well once you understand costs well and understand how those costs help in generating revenues to pay for the costs.
REVENUE - COSTS = PROFIT
UNDERSTAND COSTS
YOU CANNOT UNDERSTAND REVENUE WITHOUT UNDERSTANDING COSTS.
Understand Nature Of Costs In A Business
One needs to understand the nature of costs because revenue generation requires costs to be taken up upfront. On a time line, costs always comes first. On P&L representation, revenue is written down first but costs should be looked at carefully.
Hello Costs
Variable Costs
Variable costs are the costs that are directly linked to each unit of good or service sold to generate revenue. Variable costs help in understanding unit economics of the business.
Hello Costs
Fixed Costs
Fixed costs are the costs that are required to be incurred irrespective revenue. These are cost that you have to pay on your obligations even at zero productive activity of your business.
Hello Costs
Semi-Variable/Fixed
Semi Variable Costs Or Semi-fixed costs are the costs that may have some component as variable and some component as fixed. We will discuss these below.
Real Estate Rent (Workspaces, Land, Factories) • Machine Rents
Rents are usually fixed costs. When you are doing a business, you have to rent out a piece of real estate which becomes your place of doing business. Traditionally the rents have a fixed nature but these can also be designed in a way that a part of the rent becomes a monthly fixed costs and a part of it is paid as a direct proportion of the revenue that the business generates.
For example, if you are running a coffee house business, you will have to take up a space and pay rent for it to the owner of the space. In this is case, even if you do zero sales from your coffee house in a month, you will have to pay a fixed monthly rent and it remains your pure fixed cost.
Now suppose you are able to strike a deal with the owner of the space and you two decide on a lower fixed rent and you will also pay a share of the revenue to owner, the rent become a hybrid cost and the two components of the rent may be treated separately. The fixed component is treated as a fixed cost component and the share of revenue is now required to be treated as a variable component from fundamental point of view. These types of arrangements are very common in large retail areas such as malls and airports.
Now even if you have purchased the place and taken up a loan for making such purchase, you may become the owner of the space but still you may have to make monthly payouts to the bank in terms of monthly EMIs. This form of obligation also becomes type of rental payment. This is a fixed cost in your P&L. Depending upon he accounting rules of the country, the representation may vary in your P&L.
Electricity Costs • Internet Costs • Telephone Usage Costs • Water Usage Costs etc.
Utilities are also fixed costs in most of the cases.
Internet costs are usually fixed monthly costs because you have to buy monthly data packages. even if you do not use internet for a month you will still have to pay subscription charges. Similar is the case with Telephone usage costs.
Electricity and water may have a hybrid nature. There is usually a fixed component in each month's bill that needs to be paid as per the capacity that you have planned electricity load or water. If you are in the business of manufacturing, your usage of electricity or water may vary depending upon production for the months.
To keep life simple, utilities are usually treated above EBITDA and below Contribution Margin. (Oh My Got, Big Words. Don't worry these things will lturn out to be easy to understand once you are able to understand costs well).
Accountants, Legal Counsel Retainers • License Renewals
Compliance costs are related to the costs you have to incur on monthly or annual basis to remain compliant with the rules and regulations of the market you are doing your business in. These may relate to business license renewals, compliance related reporting, monthly or annual fees paid to accountants or legal counsels.
Fixed Salaries • Annual Bonuses • Meals • Insurances • Medical Camps
Employees related expenses are usually a combination of fixed and variable components. Fixed monthly salaries are paid on monthly basis irrespective of total productivity. Annual bonuses are paid on the basis of firm's profit performance. Other benefits such as meals relate costs, insurances, medical camps are discretionary in nature. All these costs are usually recorded after Contribution Margin (CM) and before EBITDA.
A firm may purchase insurance to cover business losses in case of some unexpected or unforeseen events. These insurance premiums are paid on anuual or monthly basis. The insurance costs are significant component of any business.
Any business requires large sums of money to be able to achieve its true potential. Sometimes a large opportunity arises and cash in account may not be enough to cover immediate costs before the opportunity (business) starts to pay off. These opportunities can be supported by taking loans from banks and financial companies
We took a contrarian approach in touching upon various types of costs. Wherever you read about profit and loss statements, you will see cost of goods sold (COGS) at the very beginning. Now that we are discussing about these costs, let us spend some time here. COGS is a cost of all preliminary ingredients that go into each unit of final product that can be sold directly. In the case of physical goods, it covers all raw materials used in producing that product as well as cost of all the packaging in which the product is sold. It is the sum of costs of all the individual items that go into the final product. The cost of goods sold determine what is the margin earned per unit of product sold.
In the digital era, there is a cost that is charged per unit of monetary value of the product when payment is processed via a digital payment gateway. This is called payment processing cost. This is a direct variable cost that varies with every unit of payment processed through digital payment gateways. This one gets overlooked a lot of times initially and management wakes up after achieving a scale where this one starts to look very big on absolute terms.
Commissions are the amounts paid to the mediation channels who help in selling the products and services. These are also charged by the mid channels as a percentage of sales made. For instance, if you selling your goods through an e-commerce channel, the channel will take a percentage of your earnings as commission. Thus, these commissions are direct variable costs that vary with each unit of product or service sold through a channel.
Marketing and advertisement costs are the costs taken up to make people aware of the products and services and help them make decision about purchasing your products. These costs can be fixed costs or variable costs depending upon type of expenditure to bring the revenues. If you hire an advertisement agency to create and advertisement for you and run it, it becomes a type of fixed cost for the period. It can bring in zero sales or can bring in multifold sales. Thus these are not attributable to each unit sold.
On the other hand if you give discounts to customers on each unit sold, this cost becomes a variable cost. As we will discuss later, this is not a good strategy.
We keep updating above section from time to time as new business models reveal finer nature of costs and we feel that they need some merit touching upon.
Now it is a good moment to start understanding the profit & loss statement. We will also try to touch upon the MBA course topics that relate to these lines. You will be surprised to see that a single concept such as marketing is related to cost as well as revenue. There will be more such examples.
Components Of A P&L Statement
A typical profit & loss statement has below flow/structure
Revenue comes from sales of your goods and services. Sales comes from selling each unit of goods and services at a certain price point. The number of units that you are able to sell at a certain price point determines the total value of your revenue in a certain period. Thus you can say that revenue equation can be stated something like this
Revenue = Price x Quantity
This seemingly simple equation carries so much depth that it can keep you awake for nights and months to perhaps years if the scale of total revenue after removing for all directly related costs is not large enough to to cover your fixed costs at least.
The sales relates to almost every subject your are going to study in a MBA program. It related to R&D and product development because your product should have certain qualities that makes a customer pay the price to acquire your product to get a certain job done.
It relates to all types of marketing that make people aware of your existence and existence of your products so that some of them buy your product.
It relates.to concepts of pricing strategies that strategically price a product to communicate. economic and emotional value and translate them into a tangible monetary. number.
It relates to packaging design, statistics, supply chain management, inventory management, and so much more.
Later we will see that valuing a company just on the basis of revenue is a mistake and how quality of revenue matters rather than total revenue figure.
Remember the equation above? Revenue - Costs = Profits?
The acquaintance to profits and long term relationship with profits and losses starts here.
Profits are also called as Margins interchangeably. So do not get confused between these two. Mostly the term margin is used in day to day language.
Gross Profit Or Gross Margin the profit a firm makes on each unit of goods or services sold after removing the direct costs associated with production of the good or service.
Thus, Gross Profit = Revenue - Cost Of Goods Sold (COGS).
Gross margin is a valuable concept in finance as it helps us know whether the firm is making enough margins on products sold to be able cover all the other costs of doing business.
Contribution Margin is a purely management concept. When a P&L is reported to country authorities, contribution margin word is not used. From accounting reporting point of view, contribution margin and gross margin (above) are same.
The reason we discuss Contribution Margins (CM) in management discussions is that this breakdown helps the management breakdown the cost parts better and more comprehensible manner for efficient decision making.
In every firm, there are two reporting formats - one format for accounting reporting and one format for management decision making about business. Fundamentally the cost components remain same. CM is in a way a pitstop margin for better breakdown of costs and margins. Every firm may have its own way of looking at CM depending upon what costs they include for assessing pitstop margins.
They can have different levels of margins such as Contribution Margin 1 (CM1) , Contribution Margin 2 (CM3) and so on. To keep matters manageable, it makes sense to limit such breakdown to CM3 or at the maximum to CM4 (althouugh we feel that there is usually no need to go beyond CM2).
EBITDA is the term you will hear most of the times when the performance of a company is discussed. Once you subtract all the operations related costs from firm's revenues you arrive at EBITDA. It is a measure of Operational Profitability of the firm.
EBITDA is the abbreviation of Earnings Before Interests, Taxes, Depreciation, & Amortisation.
By now you must have guessed it correctly. Profits, Margins and Earnings are all same. They basically represent what is left (as earned) after subtracting all cost obligations from the Revenues.
Interest costs, and Depreciation and Amortisation related costs will be covered slightly late. We will give you a link here when we do the same.
These are also a type of cost but not exactly related to day-to-day operations of the business.
Now we will switch. our language to more formula oriented one so that we are able to focus more on operational profitability first and arrive at downstream profitability once we have gained a solid understanding of the same.
EBIT is Earnings Before Interests & Taxes. It is basically arrived at by subtracting depreciation and amortisation related costs.
EBT is Earnings Before Taxes. The taxes on a business are calculated on net earnings after removing all the costs. Interest paid on loans is also a type of cost.
Later you may come across a concept that interests provide Tax Shield. This is that shield. Tax is calculated after subtracting interest from residual earnings.
Net Earnings are arrived at by subtracting taxes from the profits after removing all the costs.
For instance, assume that you firm is left with $1 million in profits after removing all types of costs from revenues and corporate tax is 20%. Thus, a 20% of that earning which comes out to be $200k is paid to the government and rest $800k is left with the firm owners as net profit or net earnings.
What happens when the firm is in losses? Good Question. Hold on to it. You will come across this soon.
Please note that all the components discussed above are related to the concepts of debt and equity in a business and will be carefully assessed to find out the value of a business.
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Debt
How is debt related to above discussion. If you noticed, the tax on profits are calculated after subtracting interest on debt from the net earnings. Taking on interest cost on P&L helps shield some part the profits against taxation. Thus the use of a healthy amount of debt capital can be helpful in company but taking a debt to just save on taxes is not the primary goal.
Equity
Equity holders are always paid from the final remaining profits of a firm. They have participation in gains as well as participations in losses.
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