When a company wishes to know its financial position and the economic results obtained from its activities over the year, it must turn to economic and financial analysis — and, in particular, to the profit and loss account, also known as the income statement, which reports the company’s income and expenses. If the difference between them is positive, we have a positive net profit; otherwise, we have a loss.

The information presented in the profit and loss account is of interest to the management, the owners, the company’s creditors and even the State.

What is the profit and loss account?

The income statement is a document that sets out all the income generated by the company and all the costs and expenses incurred during its operations, in order to show its result. In other words, it shows the profit or loss of the business over a given period, which may be a year, a month, or any period desired.

It does not deal with cash, but with accounting profit or loss; that is, it shows whether we have sold or bought, but it does not reflect whether we have collected the sales or paid for the purchases.

That is why the profit or loss reported by the profit and loss account will not necessarily be reflected in the company’s cash. As mentioned above, the running of the company generates income and expenses, from the difference between which the result for the period arises:

Ordering the income statement and its analysis

Before turning to the structure or ordering that should be adopted in the income statement, we must know whether the profit or loss is being recognised on a cash or an accruals basis.

Elements of the income statement

This report is guided by the provisions of the Spanish General Chart of Accounts and classifies expenses by their nature. There is a standard model and an abridged model, and, optionally, a list format (classifying expenses by nature, i.e. the analytical model). There are two main categories in the profit and loss account, which can be summarised in the following table:

Whichever model you use (standard, abridged or analytical), the items of the profit and loss account are ordered as follows:

• Income (net sales): This entry reflects the value of the goods and services the company has sold to its customers, i.e. the income arising from the company’s own operating activity. Sales are usually presented net, so that returns, invoice rebates, taxes, discounts, and so on, are deducted.

• Manufacturing costs: These may be variable or proportional and comprise all manufacturing costs attributable to sales, such as (direct manufacturing) labour, raw materials and direct manufacturing expenses.

• Selling costs: As in the previous case, these may be variable or proportional and, as the name indicates, comprise all selling costs attributable to sales, for example, delivery costs on sales, commissions, advertising expenses, and so on. These are also known as the cost of goods sold or cost of sales.

• Depreciation and amortisation: The charge for the period reflecting the wear and tear of non-current assets, whether tangible or intangible.

• Structural costs: These costs are not attributable to sales; they arise from the company’s structure and are also called fixed costs. Here we find, for example, the salaries of the accounting, personnel and management departments, and so on.

• Other expenses and income: This includes all expenses and income that cannot be placed in the other groups mentioned. For example, operating grants, interest income/expense, net losses on derivatives, income from the company’s staff shop, and so on.

• Financial expenses and income: This includes all of the company’s financial income and expenses. It groups not only bank charges such as commissions and interest, but also the financial interest received by the company, such as early-payment discounts.

• Corporation tax: This is the tax on the profit for the period, which is distinct from the other taxes the company pays, such as the tax on economic activities.

Analysis of the profit and loss account

Because this account contains information that is important for calculating certain financial ratios, it can be used to measure the company’s position and performance during the reporting period. This analysis can be carried out, for example, through:

• Checking figures year on year, with horizontal analysis, or by benchmarking the company.

• Margins: whether the gross profit margin, the operating margin, the net profit margin or the EBITDA margin.

• Trend analysis: here we must observe whether the metrics are deteriorating or improving.

Among the easiest yet most effective items to analyse in the profit and loss account are:

1. Sales: Although it may seem obvious, the first thing to review is sales, since increasing sales is usually the best way to improve profitability. For example, if we see that a given month was good, we should perhaps review why, so that we can try to repeat it in the future.

2. Seasonality: This allows us to visualise how things change in the company according to the season.

3. Sources of income: We can find out whether our company’s sources of income make sense and/or whether they are profitable for our business.

4. Cost of goods sold: Put simply, it makes sense for the cost of goods sold to rise as income rises, since these expenses are related; what would not make sense is the opposite.

To establish all of the above, we must take the following elements into account:

• Gross margin: A percentage calculated as the company’s net sales less the cost of goods sold, divided by net sales. Its formula is: Gross margin = (net sales − cost of goods sold) / net sales.

• Profit margin: The relationship with the amount of profit (once all expenses and income taxes have been deducted). It is calculated with the following formula: Profit margin = net amount after tax / net sales.

• Earnings per share: This shows the amount of a company’s net profit per ordinary share. Most shareholders follow this ratio very closely, as it is a valuable criterion for risk management. It is calculated as follows: Earnings per share = net income after tax / average number of ordinary shares outstanding.

• Return on equity after tax: In other texts this may be found as return on capital; this ratio is used in analysing the company’s profitability. To calculate it we can use the following formula: Return on equity = net income for the year after tax / average equity during the year.