The statement of profit or loss provides a window into a company’s performance over a specific period. Beyond numbers on a page, this financial statement tells a story of hard-won revenues, the costs incurred to achieve them, and the balance between ambition and efficiency.
For investors, it serves as a roadmap, guiding them through the complexities of revenue generation, cost control and, ultimately, long-term sustainability.
So, what is the statement of profit or loss, why is it important, and how do investors use it to aid decision-making?
Be sure to reinforce your learning with our free quiz at the end!
What Is The Statement of Profit or Loss?
Often called the income statement, the statement of profit or loss provides an overview of a company’s financial performance over time. It shows the total revenue, the expenses incurred to generate it and what’s left over after accounting for these expenses – profit.
For public companies (those listed on the stock market), statements of profit or loss are prepared and published to the public at the end of every quarter and their financial year.
Why Is The Statement of Profit or Loss Important?
Like the statement of financial position and the statement of cash flows, the statement of profit or loss is a primary financial statement. It informs stakeholders about an entity’s profitability and how efficiently it generates profit.
Other reasons of importance include the following.
Performance Comparisons
The statement of profit or loss allows investors to compare a company’s performance over time. Because it’s presented the same way every time, investors can identify trends in revenue, expenses, profits and profit margins.
Similarly, the statement of profit or loss allows investors to compare companies against their industry peers. Because of the statement’s standard layout, investors can determine whether a company is growing faster, more profitable and more operationally efficient by comparing it to its closest competitors.
Basis for Financial Ratios
Essential profitability ratios, including gross and operating margins, are derived from the statement of profit or loss. These ratios give investors insight into a company’s efficiency. High profitability ratios suggest that a company is operationally efficient – producing increasingly more revenue while keeping costs low.
The statement of profit or loss is also used for cross-statement ratios. Metrics like ROIC (return on invested capital) and ROCE (return on capital employed) use profit to determine how effectively a company allocates capital (from the statement of financial position) to profitable investments.
Valuation
Because it provides insight into a company’s financial performance, the statement of profit or loss plays a crucial role in the valuation process.
Companies with growing annual revenues and profits are highly valued. If a company has competitive advantages that allow it to grow and scale uninterrupted, it is priced even higher.
On the contrary, companies with stagnant or declining annual revenues and profits are priced much lower.
Components of the Statement of Profit or Loss
All statements of profit or loss have three distinct components: revenue, expenses and profit (or loss). These components work together to provide insight into a company’s financial performance.
Here’s a breakdown.
Revenue
Revenue is the total income generated from a company’s day-to-day operations, typically by selling a good or service. It is sometimes called the “top line” or “top line revenue” because it is the first figure on a company’s statement of profit or loss.
Two factors determine a company’s revenue:
- The total number of goods sold/services provided
- The selling price per good sold/service provided.
So, if a company sells 2,000 laptops for £800 each, its revenue would be £1.6 million (2,000 x 800).
For a more in-depth article breaking down revenue, click here.
Expenses
Expenses are the costs incurred from running and managing business operations, generating revenue and making investments. They represent outflows of economic resources that decrease the profitability of an entity.
The three main categories of expenses that appear on a statement of profit or loss include:
- Cost of Goods Sold (COGS) – the costs directly related to producing a good or developing a service.
- Operating Expenses (OpEx) – the recurring costs of running a company’s day-to-day operations.
- Non-Operating Expenses – costs like interest expense and investment losses that arise from activities unrelated to a company’s core operations.
For a more in-depth article breaking down expenses, click here.
Profit (or Loss)
Profit is the total gain a company achieves after accounting for expenses. Calculated by deducting expenses from revenue (revenue – expenses), profit is one of many indicators of financial success.
The same equation that governs profit also governs financial losses. When expenses exceed revenue, the company yields a loss – it spent more than it generated in revenue.
For a more in-depth article breaking down profit, click here.
Statement of Profit or Loss Format and Layout
Statements of profit or loss are presented slightly differently based on the company’s country of origin and the financial reporting standards followed.
For countries that follow the International Financial Reporting Standards (IFRS) – most countries except the US – their companies present their statements of profit or loss in the following way.
For countries that follow the Generally Accepted Accounting Practices (GAAP), mainly the US, their companies present their statements of profit or loss in the following way.
And The Difference?
The differences are only slight. They include:
- Headings – companies that follow GAAP use “Statement of Operations”, while companies that follow the IFRS use “Statement of Profit or Loss.”
- Line item names – companies that follow GAAP use “Operating income” and “Net income”, while companies that follow the IFRS use “Operating profit” and “Profit for the period.”
How Investors Use The Statement of Profit or Loss
The statement of profit or loss allows investors to analyse a company’s financial performance. But how do they go about this analysis?
Financial metrics.
Several financial metrics can be calculated from the statement of profit or loss, including the following.
Revenue Growth
Revenue growth tells the change in revenue, either in money terms or as a percentage, from one year to another, showing how fast a company is growing its revenue. Investors are often attracted to companies with high revenue growth because it indicates market dominance and a potentially higher stock price in the future.
Revenue growth is calculated in the following way.
Revenue Growth (in money terms) = This Year’s Revenue – Last Year’s Revenue
Revenue Growth (as a percentage) = (This Year’s Revenue / Last Year’s Revenue) – 1
Gross Margin
Gross margin measures the percentage of revenue remaining after accounting for all production (direct) costs.
Investors are attracted to high gross margin companies because it suggests the company has production expenses under control – it can generate proportionately more revenue without drastically increasing direct costs.
Gross margin is calculated in the following way.
Gross Margin = (Gross Profit / Revenue) x 100
Operating Margin
Operating margin measures the percentage of revenue remaining after accounting for direct costs and operating expenses. High operating margins mean a company is operationally efficient – it maximises revenue generation while keeping operating costs to a minimum.
Operating margin is calculated in the following way.
Operating Margin = (Operating Profit / Revenue) x 100
Net Margin
Net margin measures the percentage of revenue remaining after accounting for all business expenses. Investors are attracted to companies with high net margins because it suggests the company’s cost of doing business is under control.
Net margin is calculated in the following way.
Net Margin = (Net Profit / Revenue) x 100
Section Summary
Profitability metrics allow investors to analyse the underlying fundamentals of a company’s financial performance. Investors are drawn to companies with high margins because they generate increasingly more revenue while keeping costs in check.
The more efficient a company, the more profit it generates and the greater the investor’s rewards (higher share price and more dividends).
Summary
The statement of profit or loss is the primary financial statement for understanding a company’s profitability and operational efficiency. By providing insights into revenue generation, cost management and profit margins, it guides stakeholders to more informed decisions.
For investors, the statement of profit or loss provides a gateway for thorough analysis, offering clues about a company’s ability to sustain growth, adapt to challenges, and deliver shareholder returns. When analysed alongside other financial statements, it paints a holistic picture of a company’s market position, helping to identify future potential and risks.
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