Finance for Management Series Part 3: Reading the 'Flow' of the Income Statement—How Was That Profit Created?
"We are in the black this year."
"We are generating solid profits."
When you hear these words,
there is only one question a manager should ask next.
As a result of what kind of "flow" was that profit created?
The P&L (Income Statement) is
not something that shows a company's "savings balance."
That is the role of the BS (Balance Sheet).
The P&L is strictly
how the company moved over a certain period,
a "flow of activities"
captured by accounting rules.
If you lose sight of this premise,
the P&L becomes a set of numbers that will immediately lead to incorrect management decisions.
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■ The P&L is not a stock. It is a flow.
First, let's make this clear.
• BS: The state at a certain moment (stock)
• PL: The flow of activities that occurred over a certain period (flow)
• CF: How money actually moved during that period (facts within the flow)
While the P&L is a "result,"
it is not an accumulated state.
It is a compilation and edit of the flow of transactions such as daily sales, costs, salaries, expenses, interest, and exchange rates.
Therefore, the P&L is a story
that tells "what happened,"
not a table that shows the "strength of the company" itself.
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■ The purpose of looking at the P&L is not to know the "profit amount"
The purpose of looking at the P&Lis not to confirm "how much money was made."
The true purpose is
to understand the structure of the flow—
which activity,
where,
and how it created profit (or loss).
What is provided for that purpose
is tiered profit.
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■ Tiered profit is a "mechanism for breaking down the flow"
Let's re-examine the structure of the P&L as a flow.Net Sales
↓
Gross Profit
↓
Operating Profit
↓
Ordinary Profit
↓
Profit Before Income Taxes
↓
Net Income
This is
not about "the higher up, the more correct" or "the bottom is the final conclusion."
It is simply breaking down the flow
into layers with different meanings.
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■ Gross Profit: The flow of value creationGross profit is
"the money that remains first as a result of delivering value to the market."
• Was the pricing appropriate?
• Is cost management functioning?
• Are you in a flow of selling based on cheapness?
Gross profit reflects the flow of the business model itself.
A company that is thin here
will struggle no matter how hard it tries in the later stages.
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■ Operating Profit: The flow generated by the core business
Operating profit isthe result of isolating only the core business activities. • Using people
• Operating equipment
• Selling
• Managing
Within that flow,
did the core business generate a plus?
A company where this is in the red,
• Ordinary profit is in the black
• Final profit is also in the black
is in a state of
depending on flows other than the core business.
That is not muscle; it is an IV drip.
⸻
■ Ordinary Profit: The "flow of normal operations"
Ordinary profit is
• The flow of operating activities • The flow of financial activities (interest, etc.)combined.
In other words,
it is the level of "how this company moves if nothing special happens."
The reason banks emphasize ordinary profit is
because they are looking at the "normal flow" that serves as the source of repayment.
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■ Extraordinary Income/Loss is "outside the flow"
Extraordinary income/loss is essentially
a place to process events outside the normal flow, such as:
• Disasters • Large-scale asset sales • Business withdrawals
However, in practice,
• Distortions that occurred in the core business
• Losses that occur every year
are often pushed here.
If it happens every year, it is not extraordinary.
This is an iron rule for reading the P&L.
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■ Net Income is merely an "edited figure"
The final profit stands out.
However, it does not serve as the axis for management decisions.
The reason is simple:
• Taxes
• Accounting treatments • One-time factorscan easily change it.
Net income is a "result display"
where the flow has been edited by accounting rules,
not the strength itself.
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■ That is why "profit is an opinion"
P&L figures change depending on:
• Inventory valuation
• Depreciation methods
• Allowances
• Subsidy processingThis is not a bad thing.Accounting is, after all, an editing technique.
That is precisely why
profit is an opinion,
and it is necessary to verify whether that opinion is valid.
The places to verify this are
the BS and CF.
⸻
■ Always connect the P&L to the "next question"
Once you read the P&L,
always ask the next question.
• Is this flow generating cash?
• As a result, how did the BS change?
• Is it an unreasonable flow?
P&L → BS → CFWhen this connection is made,finance finally becomes the language of management.