How to understand the Profit and Loss Statement and why it’s confusing
We need to talk… about Profit and Loss (not boring I swear)
*rolls up sleeves and turns over hourglass*
Ok – let’s talk about the Profit and Loss Statement.
Stunning topic I’m sure you’ll agree. But actually, I am frequently stunned (stunned!) by the P&L. It does things that defy my initial expectations, even after years working in financial software. Usually, my expectations are cash-based – causing me confusion when I have (for example) spent cash but lost nothing!
I can’t be alone here – and in fact, I’m not.
The number of Google searches by people not understanding their P&L is easily double those not understanding their Cash Flow, or even Balance Sheet reports. So what makes the P&L so hard to get your head around?
The simple answer is the profit and loss report is not doing what you might think it is doing. This, I believe, is the cause of most of the confusion.
What is Profit and Loss and why is it confusing?
We all think we know what profit is. Money, right? Well, sometimes.
Profit is money that is made after the costs of making that money are subtracted. It’s what’s left over after all the bills have been paid. Logically, what I need to know then to get to a figure for profit is the total for my incoming revenue and outgoing expenditure. The difference between these figures should be my profit. Right?
Income – expenditure = profit.
This sounds right. But it isn’t the whole picture. Because the P&L doesn’t just track bills and invoices. It also tracks changes in the value of things my business owns. Value is usually what we go to the Balance Sheet to find out. But the P&L includes figures based on value too – and this is often what confuses people (me included).
For example – if my business has an investment that increases in value – this is shown as contributing positively to profit on my P&L. And if I have an asset that depreciates (like a car) then this is a loss to the business. No cash has changed hands in either case – but the business has made a profit in one case and a loss in the other.
More reasons why Profit and Loss is confusing…
Another reason why profit and loss confuses me is that it doesn’t take the timing of payments into account. I think part of the reason this confuses me is because of the way I approach financial planning.
I have not trained as an accountant – like most people the main interaction I have with money outside of work is my household finances. And in personal finance cash is absolutely king. It doesn’t matter to me that I have authorised a bank transfer that will take 3 days to complete – what matters to me is when that transfer actually happens. And so, when learning about business finances I naturally feel at home in the real world of the Cash Flow Statement.
The P&L, by contrast, is a strange world that records the money owed to me and money that I owe. When that money goes into or out of my wallet is of no account. When flipping between my Cash Flow and P&L forecasts I seem to be looking into two different worlds – but each is just as valid a representation of the business as the other – each is useful for different purposes.
Specific cases of Profit and Loss confusing me:
Delayed receipt of cash
The simplest but most common point of confusion is the timing of cash payments. Cash paid early hits the cash flow forecast before the P&L forecast, while late payments appear on the cash flow long after they show on the P&L.
Here on the cash flow forecast, we’re generating £1,000 every month from a client, but our client takes 2 months to pay us!
In May and June, we receive no cash on the cash flow forecast.
Meanwhile, on the P&L everything looks rosy… £1,000 a month is accounted for right from the start of the plan in May.
As you can see, confusing profit and cash in this circumstance could leave the business out of pocket. On reading the P&L though, we can gain some comfort that the business is owed money – money that will hopefully be forthcoming on the cash flow soon…
Ok, time for a more complicated example – investments.
- Each month, for 5 months, I intend to invest £500 in a fund.
- Each month this investment grows in value by £50.
- At the end of the 5th month, I sell the investment for its current value.
No too complex after all, eh? Let’s look at the reports:
On the cash flow forecast I can see the £500 I’m putting into the investment each month, until the final month when I receive £2250 from the sale of the investment.
What I don’t see here on the cash flow is the value of my investments increasing by £50 a month – as no cash changes hands – my investments just increase in value. This means that the origin of the £2,250 isn’t totally clear to me – I need information from the P&L to complete the picture.
On the P&L the picture is totally different.
I can see the growth – the profit I have made on my investment of £50 a month. But noticeably missing is the cash going into the investment itself! And what about the great pot of cash I get in September for selling the investment – why isn’t this on the P&L? Surely I made a lot of money… right?
Wrong! I only profited by £250 from my investment. The £50 the investment grows by each month is the only change the P&L registers. So why doesn’t it show my purchase of the investment each month, or the sale amount?
When I purchase something I pay for it in cash. But if the thing I purchase has a value equal to the cash I paid for it, then I haven’t gained anything. I’ve just switched what I have from being ‘cash’ to being an ‘investment’. Likewise, when I sell my investment I receive a lot of cash, but the only profit I make, if any, will be on the increased value of the investment. I don’t suffer a ‘loss’ from selling the investment either, because I gain cash equal to the value of the investment (and slightly higher in this case, resulting in £250 profit).
Finally – why is the P&L showing a profit of £50 each month when the investment isn’t sold until September? It’s because the P&L measures changes in value, rather than when those changes are realised in cash. An investment firm could be incredibly profitable, but unless it sells some of its investments, it may have little ready cash.
Physical assets suffer many of the same points of confusion as investments – particular their sale. But one thing that most assets do, that investments do not, is depreciate. Depreciation is the gradual loss in value of an asset, be it a car, computer or shop premises to wear and tear and gradual degradation.
Let’s take a simple situation. I buy an asset for £1,000 in May and depreciate it by £100 (10%) each month.
On the cash flow forecast, we only see the £1,000 purchase of the asset in May. This is because while depreciation is a loss to the business, it does not result in cash changing hands. If we added in paying for repairs and maintenance on the asset then these transactions would appear on the cash flow forecast – but depreciation of the asset does not.
On the P&L we don’t see the purchase of the asset for £1,000 – because in exchange for our £1,000 cash we have gained an asset worth £1,000.
So we see neither profit nor loss from the purchase when it occurs – but at the end of each month, we record the depreciation of the asset. This is a loss to the business, as the asset the business owns has declined in value.
Equity is poorly understood as a rule, but it’s quite simple. It’s the value of money invested in the business. This could be cash invested by the business owner, retained profit from the previous year’s operations or shares sold to raise cash for the business. This last example is what I’ll demonstrate here.
In May we sell £1,000 worth of shares in the business to raise some money.
On the cash flow forecast, I can see that £1,000 of cash has been generated from equity that we have released (sold) – so far so good.
But the P&L is completely blank, without a hint of this transaction. Why?
It’s another question of ‘what has been gained and what has been lost?’ And the answer, in this case, is: nothing. I have gained £1,000 cash but at the same time, the business has lost £1,000 of its value.
Finally, loans. Loans are a case of borrowing money – gaining cash up front and paying that cash back over time with interested added on top of the repayments. Can you see where this is going?
Here’s a £5,000 loan taken out in May, with monthly interest payments and capital repayments going out every month. The cash flow forecast gives us a lot of information on the loan and presents it clearly and completely.
On the P&L we only see the figures for the interest charged on the loan. The reason is – this is the only loss the business incurs from taking out the loan.
From the P&L’s perspective, the business hasn’t profited by £5,000 from taking out the loan – as the business has an obligation to pay back this £5,000 in full. The interest payments are shown as a loss on the P&L because these are losses in addition to the £5,000 that must be repaid.
I hope that’s helped you understand the relationship between the cash flow and the profit and loss reports! It’s good to have some clear examples that explain what’s happening.
How Brixx helped me understand the P&L
I mentioned right at the start that I work in financial software – my colleagues and I make a simple, flexible financial forecasting app called Brixx (you can try it for free right here). Luckily for me, I’ve never had to build a P&L from scratch – Brixx has always performed this task for me. This has helped me learn about the financial implications of real-world business activities – as Brixx generates the P&L, Cash Flow and Balance Sheet from my financial forecasts.
Even now the P&L can take a minute to get my head around sometimes (usually in the minute before my first coffee of the day). But I hope this article has helped you get a firmer grasp of Why Things Are The Way They Are in the world of profit and loss!