Profit and Loss

The profit and loss statement is the starting point: a clear summary of how much a company earns from its main activity, before taxes or financial obligations come into play.

This statement gives you an overview: how much comes in, how much goes out, and what the result of that balance is.

Pepe example

In this statement or spreadsheet, Pepe would record his income from salaries, investments, side businesses, etc., and his outgoings, as well as, in general terms, what he has paid in interest on loans and what he pays in taxes.

The aim is to calculate the net profit or net income that Pepe generates each month—in simpler terms, what Pepe has left after his obligations.

Let’s break down the main items:

• Revenue: Pepe’s gross salary. It is what the company pays him.

• Expenses: Also known as Operating Expenses, this includes the costs of his daily life. Rent, internet, electricity, water, food, transport, etc. Everything he needs to keep going month to month.

• EBITDA: represents what Pepe earns before interest, taxes, depreciation and amortization. It is the metric that measures his ability to generate income from his normal activity. Although it is calculated from the profit and loss statement, it requires a figure that appears in the cash flow statement: depreciation and amortization.

  • Depreciation: Pepe bought a car for €12,000 that he plans to use for 10 years. Each year it depreciates by €1,200 (€100 per month). It is not an expense he pays every month, but in accounting terms it reflects how his car loses value.
  • Amortization: Pepe invested in a programming course costing €600, valid for 3 years. Each year he “amortizes” €200 (about €17 per month). Again, he only paid once, but its value is spread over time.

• EBIT: Also known as Operating Profit. Similar to EBITDA, but after deducting depreciation and amortization. It reflects what Pepe earns before interest and taxes.

• Interest: the payments Pepe makes on loans or mortgages. This value can be negative (loans or mortgages) or positive, when he receives money from an investment.

• Taxes: what he has to pay to the state.

• Net Profit: what actually ends up in his bank account at the end of the month, after subtracting all of the above—the “real” money he can spend.

As you can see, this helps us understand what Pepe really earns each month and his ability to generate income.

Exactly the same applies to a company. Only instead of talking about salaries and rent, we talk about sales, operating costs, financial interest and corporate taxes.

Company

Now let’s see how all of this translates into a company’s profit and loss statement.

Revenue or Sales

• Type: GAAP metric
• Definition: The total amount a company invoices.

Expenses or Operating Expenses

• Type: GAAP metric
• Definition: All the costs a company needs to keep its main activity running—i.e. to operate day to day. Excluding the cost of goods sold, financial expenses (interest) and taxes.

You should try to understand expenses and how much weight they carry; it is not the same for a technology company as for a retailer. For example:

• Technology: has an app or digital store. Main expense: salaries.
• Retail: physical clothing store. Main expense: store rent.

EBITDA

• Type: NON-GAAP metric (you will always have to calculate it)

• Full name: Earnings Before Interest, Taxes, Depreciation and Amortization

• Definition: Although it appears in the Profit and Loss statement, it requires a value from the Cash Flow statement: Depreciation and Amortization.

• Formula:

  $$\text{EBITDA} = \text{EBIT} + D\&A$$

• Purpose: To assess the company’s ability to generate profit from its main activity only, without considering interest, taxes or accounting effects such as depreciation or amortization.

EBIT

• Type: GAAP metric
• Full name: Income from Operations or Operating Income
• Definition: Reflects what the company earns before interest and taxes, but after accounting for depreciation and amortization.
• Purpose: To assess the company’s ability to generate profit from its main activity including the accounting effects of depreciation and amortization, but before interest and taxes. This metric gives a more realistic view of operating efficiency, because it already reflects the wear and tear on the assets the company uses to generate revenue.

Interest

• Type: GAAP metric
• Definition: Represents the payments the company must make on loans or credit, or the income it receives from financial investments.

Taxes

• Type: GAAP metric
• Definition: The amount the company pays to the state, according to current tax legislation.

Net Profit (Net Income)

• Type: GAAP metric
• Also known as: Accounting profit (not real—money you cannot spend yet)
• Definition: It is the final result after subtracting all expenses, interest and taxes. It is the Accounting profit (not real) that the company earns after expenses and taxes. Not real because it is not the money that the company actually receives in its account and can spend. Net Profit has to go through one more statement—the Cash Flow.

Diluted EPS (Earnings Per Share)

• Type: GAAP metric

• Definition: This metric shows how much profit corresponds to each share of the company. Diluted refers to the additional shares a company issues, for example to pay employees. This is very common in the Technology sector. When the company does this it dilutes us as shareholders—like sharing the pie with more people; the more people, the smaller each slice.

• Formula:

  $$\text{EPS} = \frac{\text{Net Profit}}{\text{Diluted shares outstanding}}$$

• Purpose: To quickly assess whether shareholders might get positive or negative surprises.

  • If EPS grows, it indicates that the company generates more profit per share.
  • If it falls, it can mean that the company is issuing too many shares or that its profits are declining.

Main Profit Margins

Profit margins help us see how efficient and profitable a business is.

Pepe example

If we think about Pepe, we want to know what percentage of the “money that comes in” actually becomes profit after his expenses.

EBITDA margin

Formula:

Example:

• Revenue: €1,000
• EBITDA: €700

EBITDA margin = (700/1000) * 100
EBITDA margin = 0.7 * 100
EBITDA margin = 70%

Interpretation: A 70% EBITDA margin means that for every euro Pepe receives, after deducting operating expenses (rent, food, etc.) he generates a profit of €0.70 before deducting depreciation, amortization, interest and taxes.

Therefore, as analysts we want this number to be as close to 100% as possible.

EBIT margin

Formula:

Example:

• Revenue: €1,000
• EBIT: €500

EBIT margin = (500/1000) * 100
EBIT margin = 0.5 * 100
EBIT margin = 50%

Interpretation: An EBIT margin of 50% means that of every euro that comes in, €0.50 remains as operating profit after subtracting depreciation and amortization.

The difference between the EBITDA margin (70%) and the EBIT margin (50%), in this case 20 percentage points, reflects the accounting cost of asset wear and tear.

• If it is large, it means Pepe has many physical assets to maintain: car, computer, appliances, etc.
• If it is small, physical assets “weigh” little on the results, and most of the operating profit comes from the core activity.

Net margin

Formula:

Example:

• Revenue: €1,000
• Net Profit: €250

Net margin = (250/1000) * 100
Net margin = 0.25 * 100
Net margin = 25%

Interpretation: The 25% is Pepe’s final profitability. For every euro he receives, after deducting all expenses, interest and taxes, he generates €0.25 per euro that comes in.

In Pepe’s case, it is the money he can spend without harming his daily or monthly activity.

Application to companies

As you have seen with Pepe, margins show what percentage of what comes in actually becomes profit and how the wear and tear on assets and daily expenses affect it.

The principle is exactly the same for companies; here there are just a couple of additional points to bear in mind:

• Revenue or Sales: as with Pepe, they represent everything the company invoices.
• To assess a company’s productive capacity: the most useful are EBITDA margin and EBIT margin, which show operating efficiency before and after considering asset wear and tear.
• Most important: analyze their historical trend and their behavior during crises. Margins let us see whether a business is truly solid or not.
• Operating leverage: When analyzing margins, we look for them to grow over time and maintain a positive trend. If sales (or revenue) grow and margins also increase, this is known as Operating Leverage, which indicates that the company is reducing relative expenses and improving efficiency.

Professional definitions

Now that you have seen the explanation of these very important concepts, let’s set them out in a more “professional” way.

EBITDA margin

Formula:

• Definition: Measures the percentage of revenue that remains as profit before deducting depreciation, amortization, interest and taxes. It represents the company’s “pure” operating efficiency.
• Purpose: To assess the company’s ability to generate profit from its main activity only.
• Use: Used to compare operating efficiency between companies in the same sector and to analyze the historical trend of profitability before accounting or financial elements.

EBIT margin

Formula:

• Definition: Measures the percentage of revenue that remains as profit after accounting for depreciation and amortization, but before interest and taxes. It indicates real operating profitability taking into account asset wear and tear.
• Purpose: To understand how efficiently the company generates real operating profit, including the impact of its assets.
• Use: Used to assess the operating health of the business and compare it with competitors or to analyze how it behaves in periods of crisis.

Net margin

Formula:

• Definition: Indicates the percentage of revenue that finally remains as profit after all expenses, interest and taxes. It represents the company’s final profitability.
• Purpose: To measure the real profitability that translates into actual gains for the company. Net profit is not real money that the company receives in the bank; it is the money it generates after interest and all its day-to-day expenses. But one more statement is needed to identify the money that actually reaches the bank—cash flow.
• Use: Used to analyze the company’s ability to convert revenue into real profit and to assess its long-term profitability, although it is not the best indicator for comparisons between companies with different tax or financial structures. For that we can use EBITDA or EBIT margin.

Organic and inorganic revenue or sales

In the business world there are two main types of revenue:

• Organic sales
• Inorganic sales

Information on organic or inorganic sales is usually presented in the notes and discussion of the annual report, not in the main financial statements, which is why it appears in the section after profit margins.

It is important to understand that the number on its own does not tell us anything; you need to give it context by comparing it with values from previous years.

Pepe example

Now I want you to imagine that you are a personal accounts analyst, you work for a bank and your mission is to check whether the person will be able to handle the mortgage.

Pepe changes jobs and receives his severance pay together with payment for unused vacation. That month he earns €2,000 instead of €1,000, which is his usual salary.

For you as an analyst, this extra income is one-off and does not represent a sustainable increase in his salary—in other words, it does not mean that next month Pepe will earn €2,000 again; it is an isolated event caused by a job change. This could be considered inorganic growth.

By contrast, if Pepe gets a promotion or a permanent pay rise, that growth would be considered organic.

We apply similar reasoning to companies.

Organic sales

• Also known as: Comparable sales, “Same-Store Sales” or “Like-for-Like”
• Definition: They represent sales for a period compared with the previous year, without considering acquisitions or new openings. They are the sales that grow because the company, with its usual resources, is doing better.
• Importance: They are essential for assessing the real health of the business, especially in sectors such as retail or in companies with a history of acquisitions.

Inorganic sales

• Definition: They come from new openings or acquisitions. They are the sales that appear suddenly because the company has bought something new: it has acquired another company or opened 100 new stores at once. This growth does not come from an improvement in the core business, but from external expansion.
• Caution: more sales do not always mean higher profitability. The real quality indicator is profit margins. You need to be careful because some companies increase their inorganic growth to hide a deterioration in the core business.