Understanding Your Profit and Loss Statement
Small business owners started their businesses because they are passionate about the work that they do. The majority of them are not a CPA and unless they have a CPA that can explain their Profit and Loss Statements in easy to understand terms they just don’t look at them. I have worked with hundreds of small businesses that never looked at the Profit and Loss Statements. How did I know? Easy, because I saw simple mistakes that if these small businesses were reviewing these documents then they would not have submitted them to me.
Ensuring that your Profit and Loss Statements are accurate is essential because it is used to determine your business tax liability. Better yet, it is the document that you will use to help you make business decisions such as opening a second location, obtaining a loan and repaying a debt.
My goal in this article is to help you understand your Profit and Loss Statement and take the mystery out of them. So, let’s get started! P&L Statements are very simple in theory. Sales – Costs = Profits. Everything else is just breaking down these areas into more details and adding subtotals and totals. Let’s not forget that the Profit and Loss Statement is tracked by a period of time. This financial document will tell how financially sound your business is at a very high level.
A lot of times we use different words for sales, Profits and Costs. For example, Sales is sometimes referred to as revenue, income or gross receipts. Costs are usually called expenses and profit is sometimes called net profit, or net income. So don’t let the names confuse you. In fact, the Profit and Loss Statement is sometimes referred too as the income statement.
Usually your company sales (Revenue, Income or Gross Receipts) are broken down into separate sources. For example, a bookstore may break down their sales by in store sales, Internet Sales and digital sales. You would combine the three separate sales together to come up with your total sales. I find it valuable to have my sales broken down into separate categories. For example, I can see what percentage of my business is coming from digital sales compared to in store sales, compared to digital sales.
In the revenue section of the P&L statement is an adjustment group to sales. This group reflects the value related to the actual sale of your product or service. Sometimes we have to adjust our sales based upon items returned from our customers known as returns. These returns are correcting the total sales for many reasons. Maybe the product arrived broken or the customer ordered the wrong product.
The next adjustment to sales is allowances. Allowances are adjustments to sales reflecting defective products or courtesy adjustments for failing to deliver a product in the time frame agreed upon. The final adjusting item are discounts. Discounts are usually comprised of volume based or marketing campaign adjustments to sales. These two adjustments will have a negative impact on your total sales. In other words they will ultimately decrease your total sales and correct your records by letting you see how many times you had returns or allowances happen in a certain period of time.
The last two adjustment areas under sales are Capital Gains and Interest. If you sell an asset of the business you must record the sale and any profit on the sale as a Capital Gains. The last adjustment is Interest. If you received interest for money that you have invested then it needs to be included in your sales.
Here is a sample of a P&L statement so that you can see what we have discussed thus far.
Profit and Loss Statement 1 Jan thru Dec 30, 2010
|Sales||December||Year To Date|
|Books – Internet||$400,000||$1,000,000|
|Books – Store||$150,000||$800,000|
|Books – Digital||$350,000||$2,000,000|
|Less Allowances||Books – All||$5,000||$150,000|
|Less Returns||Books – Store/Internet||$6,000||$200,000|
Now costs are also broken down into different components. For example, you may see overhead costs, material costs, and labor costs. There are an infinite number of ways that costs can be broken out. Most accounting software will automatically break out the costs based upon the type of business that you told the software that you are operating in.
One of the most practical ways to subdivide costs is into those that are directly associated with producing your product or service and those that are not. For example, a manufacturing firm will have the costs of the raw materials for making the product, the cost of the employees that assembling the product and the costs of the production facility. These associated costs are referred to as the Cost Of Goods Sold (COGS) because are directly related to producing the product.
Like wise the service industry would break out the costs associated with their service. For example, a lawn care business would break out the costs of fuel; cost of employees who work on the customer lawns and the cost of grass seed, or fertilizer for example and these costs would be called Cost Of Services (COS).
Sales minus COGS is known as Gross profit (sometimes referred to as Gross Margin). This is the money the business earned after producing the product or service. It is also the money that is used to cover the other costs of running a business that has not been taken into account as of yet. By taking your gross profit by total sales will tell you your Gross Profit Margin Percentage. You can use this percentage to compare your business with other businesses in the same industry. More information on this technique will be posted in future blogs.
Now I bet you are wondering where the other costs not associated with the production of products or services get listed? Well these costs, costs of people that sell the product, office personnel not involved in producing the product or service and even your salary are listed in a section called General and Administrative Costs (G&A). So we can see that the P&L is broken down into two parts: sales –(minus) COGS=Gross Profit and Gross Profit – (minus) G&A = profit.
The bottom line of any business is the profit left after all associated costs of running the business. The more profit the better off your business is and of course the more taxes you have to pay.
Now I hope you will get out those Profit and Loss Statements that you have been filing away all these years and look at them. Remember that your P&L Statement is a good indication of your financial health of your business. Here are a few things for you to pay attention to in order to not only avoid problems but to spot them before they hurt your business.
- Increasing Sales and Declining Profits. This is a good indication that something is wrong. Look at your costs. Have they increased? Is there a way to change your margin? Are you growing too quickly? You need to find out what is happening here.
- Stagnant Sales – Do you need to find a new market? Offer a new product? Increase visibility? Looking for diverse opportunities for growth will safeguard your business. You should have seven (7) revenue streams at all times to help with this.
- Creeping Overhead – Keep tabs on overhead costs like utilities, salaries and rent. Always shop around as you may find that you can switch providers or locations and cut costs without sacrificing profits.
- Increased COGS – If your cost of goods sold is increasing, find out why? It the increase industry-wide or should you review your suppliers? Is it the economy?
To determine if your profits and Gross Profit Margin are within the appropriate range for your business type and location, you should benchmark to see what the market bears and what to aim for. Since you rarely have access to competitor information you can do this internally. Compare month-to-month, quarter-to-quarter and year-to-year. This way you will be able to set goals effectively and ensure your business growth over time.
It may take a little time for you to get the hang of managing your P&L Statement, but once you do you will be glad you did.