How to Read a Profit and Loss Statement
- A worked example
- The income lines
- The expense lines, and the one that confuses everybody
- Five figures worth computing
- What the statement does not tell you
- A reading order that works
- Where this fits
A profit and loss statement tells you what a business earned and spent over a period, and what was left. Read it top to bottom and it answers three questions in order: how much did the business sell, what did it cost to run, and how much of the difference belongs to the owners after interest and tax.
Indian companies present it in a fixed layout under Schedule III to the Companies Act, 2013, where it is called the Statement of Profit and Loss. Once you know that layout, any company’s statement reads the same way. Proprietorships and partnerships are not bound by it, but most accountants follow a similar order, so this guide works for them too.
A worked example
A small manufacturer’s statement for the year, in ₹ lakh:
| Line | ₹ lakh |
|---|---|
| Revenue from operations | 1,200 |
| Other income | 20 |
| Total income | 1,220 |
| Cost of materials consumed | 540 |
| Purchases of stock-in-trade | 60 |
| Changes in inventories of finished goods, work-in-progress and stock-in-trade | (30) |
| Employee benefits expense | 180 |
| Finance costs | 36 |
| Depreciation and amortisation expense | 48 |
| Other expenses | 190 |
| Total expenses | 1,024 |
| Profit before tax | 196 |
| Tax expense: current tax 45, deferred tax 4 | 49 |
| Profit for the year | 147 |
The income lines
Revenue from operations is what the business earns from what it exists to do: selling goods or services. It is the figure every margin should be computed on.
Other income is everything else: interest on deposits, rent from spare space, a profit on selling an old asset. It is real money, but it says nothing about how the business itself performs. A company whose profit depends on other income is running a treasury, not a factory. Here it is ₹20 lakh against ₹196 lakh of profit before tax, which is modest.
The expense lines, and the one that confuses everybody
Cost of materials consumed is raw material actually used in production, not what was bought. Purchases are adjusted for opening and closing stock of materials before they reach this line.
Purchases of stock-in-trade is goods bought to resell without processing.
Changes in inventories is the line people misread. It adjusts expenses for finished goods and work-in-progress that were made this year but not sold, or sold this year but made last year.
- If closing stock is higher than opening stock, some of this year’s production cost is sitting in the warehouse, not in the goods sold. The line is negative, reducing expenses. That is the ₹(30) lakh above.
- If closing stock is lower, the business sold goods made in an earlier year. The line is positive, adding their cost.
A large negative figure here deserves a question. It can mean healthy stock-building ahead of demand, or it can mean production that did not sell, now carried at cost on the balance sheet.
Employee benefits expense covers salaries, wages, contributions to provident and other funds, gratuity and staff welfare.
Finance costs is interest and related borrowing costs. It shows how much of the operating result goes to lenders.
Depreciation and amortisation spreads the cost of machines, buildings and intangibles over their useful lives. It is a genuine cost but not a cash payment in the year, which matters when you compare profit with cash.
Other expenses is everything else: power, rent, repairs, freight, marketing, professional fees. The notes break it down, and the breakdown is usually where the useful detail is.
Five figures worth computing
| Measure | Computation | Result |
|---|---|---|
| Gross margin | (1,200 − 540 − 60 + 30) ÷ 1,200 | 52.5% |
| EBITDA | 196 + 36 + 48 − 20 | ₹260 lakh, 21.7% |
| Interest coverage | (196 + 36) ÷ 36 | 6.4 times |
| Net margin | 147 ÷ 1,200 | 12.25% |
| Effective tax rate | 49 ÷ 196 | 25% |
Gross margin uses revenue less the cost of goods sold, which is materials, purchases and the inventory change together. Note the inventory change is added back here because it was negative.
EBITDA adds interest and depreciation back to profit before tax, and here excludes other income, so it measures operations alone. Definitions vary between companies; check whether a reported EBITDA includes other income before comparing two businesses.
Interest coverage divides profit before interest and tax by finance costs. At 6.4 times, a large fall in profit would still leave interest covered.
For the difference between EBITDA and operating profit, and when each is the right one, see EBITDA vs operating profit.
What the statement does not tell you
It is not cash. Revenue is recognised when earned, not when collected. A year of strong profit can coincide with an empty bank account if customers pay slowly or stock builds up. The cash flow statement is where you check.
One year is not a trend. The comparative column for the previous year is printed alongside for a reason. Compare every line: a margin that fell three points while revenue grew is a different story from the headline growth.
The notes matter. Exceptional items, related party transactions and the split of other expenses sit in the notes, and they often explain a number that looks odd on the face of the statement.
A reading order that works
- Revenue from operations, against last year.
- Gross margin, against last year.
- Employee and other expenses as a percentage of revenue.
- Finance costs and interest coverage.
- Other income and exceptional items as a share of profit.
- Profit for the year, and then straight to the cash flow statement to see whether the cash followed.
Where this fits
- The other two statements: how to read a balance sheet · how to read a cash flow statement
- Getting from the ledger to the statements: trial balance to balance sheet
- Ratios from all three statements: financial ratios worth computing
- Quick conversions: gross and net profit converter · profit margin calculator