Most business owners and entrepreneurs start companies because they are passionate about the service or product they offer. It is safe to say that most business owners are not equally as passionate about accounting. Therefore, in most cases, entrepreneurs and business owners are simply not as comfortable creating or interpreting financial statements for their company as they should be. Understanding the basics of your company’s finances can help you make better decisions about your business in the short- and long-term.
One of the most important financial tools that will help you understand the financial health of your company is your business’s profit & loss statement. This financial statement is based on an extremely simple formula: sales – costs = profit.
At the end of the day, every business wants to be profitable, and this financial statement will help you determine not only if you are profitable now, but also what your business may need to change in order to increase your growth. This quick guide will help you understand not only why a profit & loss statement is so vital to your business, but also how to read and interpret it so you can make the best decisions for your company.
What Is a Profit and Loss Statement?
The profit & loss statement (P&L statement) describes your company’s profit and loss over a specific period of time, which could be a month, quarter, or year. It is one of the most important financial statements of your business. Ultimately, a P&L statement will indicate if your company is profitable or not and will help both you and any potential investors determine the financial health of your business. Your revenue, costs and expenses, and net profit are all depicted in a snapshot to clearly show the fiscal strength or weakness of the business. Also, unlike other financial documents, such as a cash flow statement, P&L statements are fairly simple to read and understand.
Sales are typically shown at the very top of the P&L statement, costs are below sales, and net profit is totaled at the bottom. While there may be many other subtotals running along the side of the P&L statement, these are the numbers that will highlight whether your company is profitable or not.
Unfortunately, many accountants and financial experts refer to similar fiscal terms in different ways, causing confusion among non-accountants. For example, sales could also be referred to as income or revenue. Expenses could be referred to as costs, and net income could be referred to as profits. In fact, even a P&L statement can be referred to as an income statement or P&L report. Described below are some of the different terms that are used in the P&L statement to help you better understand what the numbers actually represent.
The very top line of a P&L statement represents the money that your business will have coming in from any sales before any deductions are taken. In many respects, the very top line of your income statement may be as significant as the bottom line (the company’s net profit). All your business’s direct expenses and costs will be taken from this revenue number. This means that the smaller your revenue number is, the fewer expenses you will need to take out to be profitable as a company.
Direct costs are also known as cost of goods sold (COGS). These are the expenses and costs that are required to make your products or to deliver your services. For example, any costs to produce your actual goods, such as ingredients or supplies, will be included in your direct costs. If you own a bookstore, the books that you have in your store would be considered a direct cost, but the rent you are charged for your shop would not be considered a direct cost. If you only have services and no actual goods, you may have very few direct costs or no costs at all. It is important to note that direct costs are different than expenses, which include any cost of doing business.
Gross margin is also known as gross profit and is the difference between revenue and direct costs. Gross margin is significant in a financial report because it shows how much of your revenue is being used for direct costs and how much remains to pay for the company’s overhead expenses. If you determine that your expenses are larger than your gross margin for a significant period of time, you may not be able to stay in business.
All overhead expenses to run your business are included in operating expenses. This includes your direct costs as well as every other expense such as rent, advertising, supplies, payroll, internet service, website costs, telephone bills, email service, and employee benefits, to name a few. It is important to look at the operating expenses of your company in relation to the revenue to determine what percentage of expenses are consuming the company’s revenue. Additionally, knowing this percentage can help you compare it to industry standards to know if your business is doing better or worse compared to similar businesses. This can also greatly assist you when deciding when and how to expand your business.
Oftentimes, operating income is known as earnings before interest, taxes, depreciation, and amortization (EBITDA). Operating income is a business’s profitability before those amounts are subtracted.
If your company has a loan of any kind, you will have interest payments that must be made. Interest expense captures these interest payments on a P&L statement.
This line on a P&L statement will reflect either the amount of income tax that your business has paid or that it expects to pay.
Depreciation and Amortization
If you have purchased any assets for your business, you will be allowed to take that amount as a business expense and deduct it for purposes of taxes. However, some business assets lose their value over time. For example, if you have a company car, its value will diminish over time, or depreciate. Your P&L statement should account for the depreciation of your assets and indicate their current value. Some assets such as intellectual property (copyrights or patents) may have their value amortized. Amortization is a process by which the value of an asset is distributed over several months or years. There are specific amortization tables that may be used to make the determination regarding the financial value of certain assets, and this can oftentimes be a complicated process.
Total expenses are the sum of the following expense items: direct costs, income taxes, depreciation & amortization, and operating expenses.
Net profit is a business’s proverbial “bottom line.” This is the net income or net earnings of a company. To calculate net profit, you should look at your revenue at the top line and then subtract all other lines from that amount. In many cases, a business may operate “in the red,” or at a loss for some time as it builds; however, if your business expenses are too high or your revenue is too low for too long of a period of time, you may have an unprofitable and unsustainable business.
Net Profit %
This calculation is done by taking the percentage of revenue that is net profit. This calculation can help a business owner determine how much of their revenue is actually able to be pocketed as profit. If the revenue of a company is $100, and the net profit is $30, the net profit % would be 30%.
Income Accounts vs. Expenditure Accounts
When creating a P&L statement, there are two main categories of accounts: income and expenditures. Income accounts will include revenue, sales, interest income, gains, fees charged, commissions earned, and rental income. Expenditure accounts will include marketing and advertising, salaries, benefits, wages, interest expenses, insurance, telecommunications, professional fees, and taxes.
There are several different types of accounting principles that may be used as a foundation to determine the final numbers on a P&L statement.
- Revenue recognition principle – The revenue is often recognized before the receipt of cash, which will create accounts receivable on the balance sheet. This simply means that you may have billed a client for a product or service because the good or service was delivered, and you are expecting payment but have not received it yet.
- Matching principle – Expenses are matched to revenues during the time that the revenues are earned. This means that, regardless of when an expense or revenue happened, if there were costs associated with a sale, they will be matched on the P&L statement.
- Accrual principle – Revenue and expenditures will be reported when received, not when billed or during the period in which they occurred. This type of accounting principle is in stark contrast to the revenue recognition principle listed above and will report revenue or costs when they actually happen.
These accounting principles can be complex; however, the most important factor is that your method is consistent so that P&L statements may be compared accurately, using similar accounting methodologies.
Reading and Analyzing a Profit & Loss Statement
After gaining an understanding of all of the components of a P&L statement, how certain accounts are labeled, and what types of accounting methods are available, the true importance and value of a P&L statement comes from being able to read and analyze the data. Reading the P&L statement is rather simple and requires a business owner to simply look at the net profit (the “bottom line”) to see if the company is a profitable one. However, more detailed analysis can be performed between P&L statements by comparing them over time.
You may decide to prepare P&L statements on a monthly and/or quarterly basis to determine the financial health and trends of the company over time. A company may be improving or deteriorating financially, and using a P&L statement can help you assess future big-picture challenges and opportunities. Also, look at whether your P&L statement matches industry standards.
Analyzing a P&L statement can help you make forward-looking decisions by analyzing the revenue growth from either month to month, quarter to quarter, or year to year. If your business is trying new types of products or services, examining a P&L statement can help verify if these new business ventures are actually profitable. Also, if you decide to incorporate new advertising or marketing, being able to understand, interpret, and compare P&L statements can help determine if these new types of marketing or advertising are impacting the company’s revenue. Finally, P&L statements can help determine if your company is meeting industry standards and comparatively profitable and, if not, help you understand if that is due to excessive monthly operating expenses, paying higher prices for products, or not charging enough for services. Ultimately, understanding how to read your company’s P&L statement can help you determine if your company is on the right track.
Professional Bookkeeping Services
Creating, reading, interpreting, and analyzing a P&L statement may seem like an overwhelming task as a business owner. At Anderson Advisors, our experienced and skilled team offers professional bookkeeping services and would welcome the opportunity to help you develop a plan to create monthly statements for your business and interpret the data, allowing you to make the wisest financial decisions for your business. Call 866-896-6141 for a free consultation today.