The format of a P&L Account is fairly standard, even though the terminology used in your company may differ to that below:
Sales less the Cost of Sales (that is, the original cost of the things that have been sold – sometimes called the ‘Cost of Goods Sold’) equals Gross Profit; deducting the Operating Costs (the Overheads, sometimes referred to as ‘Sales, General & Administration’ – or SG&A) gives the Operating Profit; from this is deducted interest and tax (in that order) to give the Net Profit.
The Net Profit is the money left over from each sale after all the costs have been taken into consideration (the costs of buying the things that we sold as well as the costs of running the business).
Imagine you were running a business, which is part of a larger conglomerate. Your boss – who works in the Head Office – wants to discuss the profitability of your business with you and starts to talk about the Net Profit of your company.
You might start to think that this was not exactly fair. The Net Profit of a company is calculated after deducting tax. So what determines the tax that a company pays? The answer is that it is a combination of the Profit Before Tax (PBT) and the local tax rate. The government sets the rate of tax of the jurisdiction in which you are operating, so the only way to reduce your tax bill would be to reduce profits (not exactly a good commercial decision). You may therefore ask that you be measured on PBT as opposed to PAT (Profit Before Tax, not Profit After Tax – which is the same as Net Profit).
How about the interest that your company pays? This is a function of how much debt you have on the Balance Sheet (in effect, the amount of funding that comes from the banks as opposed to the shareholders) and the rate of interest that you pay. The banks (from whom you have borrowed the money) set the rate, so you have very little control over it. The amount of debt that you have is a decision that was made some time ago – just as if you have a large mortgage that you took out some years ago to buy your house (and cannot repay tomorrow without selling your house) – so the debt on a company’s Balance Sheet is a result of a funding decision made sometime in the past. The only way to repay the debt would be to sell some assets – and you need those assets to trade and to make a profit.
So you might ask your boss to judge your profitability performance on your Earnings Before Interest and Tax – sometimes called EBIT. This is the same as your Operating Profit.
At this point you might also be considering the effect of Depreciation and Amortisation. Amortisation is, in effect, depreciation by another name. While we depreciate tangible fixed assets (assets we need to run the business and can touch), we amortise intangible fixed assets (assets we need to run the business and cannot touch – such as licenses, software, patents etc.). What determines the depreciation and amortization charge in your Profit & Loss Account?
The charge is a calculation based on how many fixed assets you have (‘capex’ – or capital expenditure – decisions made in previous years) and the policy for depreciating those assets (for example – tables and chairs are written off over 6 years). You cannot change the amount of fixed assets that you have without selling them (and you do not want to do that, as you need those assets to run the business). You cannot really change your depreciation method – once it has been chosen you are obliged to stick with the calculation for consistency purposes.
So in effect you have very little influence over the depreciation and amortization charge that appears in your Profit and Loss Account – and thus you might suggest to your boss that you are judged on EBIT (as defined above) but also before D and A.
Thus, many companies will use EBITDA – Earnings before Interest, Taxation, Depreciation and Amortisation – to assess the underlying profitability of their business. They still have to pay tax on profits, interest to the bank and account for the fall in value of their assets, but EBITDA is a way of getting closer to the underlying profitability of the business.
Of course, if you have no debt, then you will pay no interest. Also, if you have very little in the way of fixed assets (a consultancy company, for example, as opposed to a manufacturing business) then you will have very little in the way of depreciation. So EBITDA may not be relevant to all businesses, but it is often used as a quick and easy way of measuring the underlying profitability of the day-to-day trading operations of a business – taking into account the items that the management team can control.
