Understanding your profit and loss statement
Your profit and loss statement (P&L) helps you understand your business performance and profitability over time. It’s sometimes called an Income statement and its main purpose is to list income and expenditure.
Whereas a balance sheet is a snapshot in time, the P&L shows transactions over a specific period of time. This can be a month, quarter, financial year or any other period, and it can be a stand-alone report or a comparative period report.
Together with the balance sheet, these two reports provide a comprehensive understanding of the financial position and performance of a business.
The profit and loss statement has two main sections: income and expenses.
All P&Ls are based on a very simple formula
Sales – costs = profit (or loss)
One of the most common reasons small businesses start producing profit and loss statements is to show banks and investors how profitable their business is.
Depending on the complexity of the business and reporting requirements you will generally see the below:
Income or Revenue
Income primarily includes main business activities such as sale of goods or services. Other income such as interest received, capital gains or income from secondary business activities is also reported.
Expenses
Expenses are usually divided into two sections: direct costs, or cost of goods sold, and expenses. Cost of goods are those that are directly linked to the provision of services or sale of goods. For example, if you buy weights from a wholesaler and sell them at a marked-up value, the cost of the weights is a direct cost, not an overhead expense.
Other types of direct costs might be importing and freight costs, contractor costs or certain equipment. Some direct costs are fixed, that is, they are the same from month to month, or they could be a fixed percentage of sales; others vary in value but are still related to the income producing activities.
Overhead expenses are all the other expenses required to run the business, regardless of the level of income: for example, rent, utilities, bank fees, accountant fees, professional development costs, vehicle costs and staff costs. Many of these costs form the basis of working out your break-even point, or how much it costs just to open the doors for business.
There are some expenses which may be reported as a direct cost in one business but an indirect cost in another type of business, for example, merchant fees or contractor costs.
The Bottom Line
Total income minus total expenses results in the net profit (or loss), is often called ‘the bottom line’. Often business owners are just interested in looking at the bottom line, but a true financial picture requires an understanding of several reports and an ability to see the big picture that the reports are illustrating.
The P&L is a vital tool to analyse for trends over time.
- What does your P&L tell you about relationships and ratios between sales and expenses, seasonal changes and annual trends?
- Have all your direct costs been allocated correctly?
- Have you recouped all billable expenses from customers?
Percentages you can use to help distill the information in your income statement
A profit margin shows you the relationship between how much you spend, and how much you make, so you get an overview of your company’s financial performance. Lenders and investors look at your profit margins to see how profitable your company is, and decide whether to give you money.
The three most important profit margins are: The gross profit margin, the operating profit margin, and the net profit margin. I will cover these in a later blog.
Financial statements help you understand the big picture for your business. With deeper understanding of your business operations and performance you can make informed decisions about your business finances.
Are you confident in reading your profit and loss statement? Would you like to know more about the relationship between costs and revenue to make better business decisions? Book a session today to examine your financial reports with an experienced business advisor.
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