One of the most important documents that a manager uses to assess her business's profitability is the profit and loss statement. Commonly referred to as the "P and L," or the income statement, it contains information about all the revenues gained and expenses incurred over a set period of time, usually a month, quarter or year. The gain -- or loss -- that occurs after expenses are subtracted from revenue are called profit (or surplus) and loss. Comparing new results to previous results says a great deal about the business's health, and the direction it's heading.
Subtract the total expenses from the total revenues to determine profit or loss. If you're reading an income statement, the result of this calculation is at the bottom. It's commonly referred to as "net profit/(loss)," with losses commonly expressed in parenthesis. The income statement usually provides financial details for each line item that makes up the total revenues and expenses.
Compare the result from Step 1 to prior results to establish a pattern. Results from one month, quarter or year on their own often mean little. Better, more educated conclusions are reached when the analyst can compare the results to those from previous periods. Be sure to compare results from a comparable period; in other words, compare fiscal years to fiscal years, months to months, and quarters to quarters for an "apples to apples" comparison.
Calculate differences and variances, and figure out why the results are better, worse or different than expected. There is always a business reason that will explain why actual results vary from what was anticipated or what occurred in the past. Variances may occur because a new client was signed and revenues -- and expenses -- increased, or perhaps a unit was closed, resulting in decreased revenues but also decreased costs. Alternatively, an external factor may cause the variance. For example, if the high price of gas is causing fewer people to purchase large, gas-guzzling SUVs, that is an external factor.
Use the results from Steps 2 and 3 to make business decisions. Remember that the pattern of increase or decrease is telling a story about the business's health. Significant revenue increases in one area provides evidence to management that it may merit additional investment, while areas that are trending down may be forced to cut costs or close, if a way can't be found to increase revenue.
- Reading income statements takes practice. The calculations are simple; finding the reasons behind the increases or decreases takes more time than the math.
- Don't forget the balance sheet. The balance sheet contains information about the business's assets and liabilities, much of which won't appear on the income statement.
Items you will need
- Current income statement
- Previous income statement, at least 1 but preferably more
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