Every year, thousands of people start businesses because they are very passionate about the product or service they plan to offer. However, many quit when they realize that having a business entails more than just that. Guess what? Understanding a profit and loss statement is vital in planning and operating your business. Only the very determined ones stick long enough to realize and learn several essential business skills needed to run a successful venture. Some of these include leadership, problem-solving, and financial management skills.
Accounting is one of the core financial management skills that every business owner needs to be well acquainted with – to be able to make sound financial decisions for their business in the short- and long term.
One of the most critical accounting tools that can help you gain better insights into the financial health of your business is the profit or loss statement. The statement enables you to determine the amount of profit your business is making now and what you may need to adjust to make the company even more profitable.
What is a profit and loss statement?
Profit and loss statements are sometimes referred to as income statements. The P & L Statement is one of the essential financial statements of any business. It is used to indicate a company’s profits and expenses over a specific period – either monthly, quarterly, or yearly. It ultimately shows if the company is profitable or not, which helps the business owner and any potential investors gauge the business’s financial health.
The financial report provides a detailed summary of the business’s expenses, revenue, profits, and losses. It also indicates a business’s ability to generate sales, manage costs, and make profits. Although the thought of it alone seems scary and difficult, P&L statements are pretty simple to read and comprehend compared to most other financial documents.
Why is it important?
P&L statements provide an avenue for business owners, investors, and managers to understand the company’s financial health. This information helps them identify promising opportunities while at the same time avoiding any undue risk. With the P&L Statements, all professional levels of the business can make more strategic business decisions. The financial statement provides a clear window into a company’s financial health, which can be very difficult to accurately gauge using any other means.
How to read and interpret the profits and loss statement
The P&L statement has a pretty straightforward format, where the sales are shown at the top, followed by the costs, whereas the net profit is indicated at the very bottom. Although the financial statement is based on a straightforward business formula (sales – costs = profit), most accounting professionals refer to similar terms in different ways, confusing non-accountants. Some of the various terms used in a profit and loss statement include:
- Cost of goods sold
- Gross profit
- Operating expenses
- Operating income
- Interest Expense
- Income Taxes
- Depreciation and Amortization
- Total Expenses
- Net profit
- Net profit %
- Income accounts vs. Expenditure accounts
Revenue is usually indicated at the top line of a profit and loss statement. It represents the total amount of income the business generates before the expenses are subtracted. All the company’s direct expenses and costs are usually deducted from the total revenue number. This means that the smaller your revenue is, the fewer expenses you will need to take out to maintain profitability. If the expenses exceed the income, it simply means that your company is making losses instead of profits.
Cost of Goods Sold (COGS)
COGS is also commonly referred to as direct costs. These are the total costs and expenses that your business encounters in the production of goods or services. It includes direct labor costs, direct factory overheads, storage costs, fixed costs, and raw material costs. COGS are directly proportional to the revenue, and they usually appear on the second line of the P&L statements. As your business revenue grows, the more resources you will require to produce the goods or services. It is important to note that COGS do not include general selling expenses, such as marketing and advertisement.
Gross profit is also referred to as gross income and is usually indicated at the bottom of the sales or revenue section. Gross income is the profit your business makes after subtracting the costs associated with producing and selling its products or the costs associated with providing and delivering its services. Gross income is usually calculated by deducting the COGS from the revenue. Business leaders use gross income to assess a company’s efficiency at using its supplies and labor in producing goods or services. It is also important to note that the gross profit/ income does not account for the fixed costs.
Operating expenses are the standard costs of running a business. The type of business usually determines the nature of the operating expenses. The OP can include many things, including paying the workers, office supplies, utility bills providing transport for the workers, etc. In basic terms, operating expenses are the costs it takes to keep the business running from day to day.
All expenses that are not directly related to the COGS are considered to be operating expenses. Generally, most businesses will try to limit their operating expenses to between 60% and 80% of their gross revenue – however, this varies depending on the business model and industry.
The operating income is also called income from operations. It is also similar to the earnings before interest and taxes (EBIT) – the only major difference is that the latter includes all non-operating income the business generates.
The operating income measures the number of profits generated from a business’s operations after subtracting the operational expenses. Calculating the operating income is vital for investors and business owners because it does not include taxes and other one-off costs that may alter a company’s profit in a given time frame.
This is the cost incurred by your business for borrowed funds. It is a non-operating expense that shows the amount of interest supposed to be paid on any borrowings – loans, bonds, etc. Interest expense on the profits and loss account usually indicates the interest paid over that period – monthly, quarterly, or annually—the greater the interest expense on a business, the more significant the potential impact on its profitability.
An income tax is a tax that the government imposes on income generated by a business. The income tax is usually the last expense figure listed on a company’s profit and loss statement before calculating the total net income. It usually reflects the amount of income tax that your business has already paid or is expected to pay.
Depreciation and Amortization
Amortization and depreciation are methods used to calculate the value of business assets over time. Businesses calculate these non-cash expenses to use them as tax deductions to decrease their tax liability. Depreciation determines the total cost of a fixed asset over its useful life, whereas amortization is the similar cost of using an intangible asset like goodwill over time. There are specific amortization tables you can use to determine the financial value of particular assets. However, this is usually an independent process that is much more complex.
A business’s profit and loss statement should account for the depreciation of tangible and intangible assets and indicate their current value.
The total expenses are calculated by summing up all the expenses – operating expenses, income taxes, direct costs, and amortization & depreciation.
The net profit is also referred to as the net income. These are the net earnings of your business. The net profit is calculated by subtracting all the costs from the revenue (listed at the top line). In most cases, a new business will operate at a loss before it gradually starts picking up and building up profits. However, if your company’s expenses are too high and the revenue is too low for a prolonged period, you may have an unsustainable business.
Net Profit Percentage
The net profit percentage helps investors and business leaders to determine how much revenue can be pocketed as profit. It is usually calculated by subtracting all the expenses from revenue and dividing the result by the revenue. You then convert the figure to a percentage by multiplying it by 100.
Expenditure Accounts Vs. Income Accounts
These are the two main categories of accounts in P&L statements. Expenditure accounts account for salaries, wages, benefits, insurance, professional fees, telecommunications, interest expenses, taxes, marketing, and advertising costs. On the other hand, income accounts include revenue, interest income, sales, gains, commissions earned, rental income, and fees.
These are the basic rules and regulations that a particular company follows while filing financial information. Several basic accounting principles have been developed for general usage. These principles form the basis upon which the final numbers on a profit and loss statement are determined.
Although accounting principles can be complex, they are essential factors in creating consistent P&L statements that can be accurately compared with each other.
All accounting transactions are recorded in the period they occur rather than when cash flows are associated. P&L statements need to indicate what happened in an accounting period, rather than being artificially accelerated or delayed by the associated cash flows.
Once your business adopts a particular accounting principle, it should continue using it until it decides to adopt another one. Not following the principle means that your business could switch between different accounting methods for its transactions, making it extremely difficult to discern the long-term financial results.
Revenue recognition principle
Your business’s revenue is acknowledged before the actual cash transaction, creating accounts receivable on the financial statement. In simpler terms, this means that you may have billed your customer for a product or service, but you have not received the due payment.
Full disclosure principle
The full disclosure principle demands that a business include all the relevant information that may impact the reader’s understanding of the financial statements. In recent years, this has become a standard in accounting, requiring companies to disclose a lot of their financial information.
Reading and analyzing a P&L statement
Once you have understood all the elements of a profit and loss statement, how the different accounts are labeled, and the various accounting principles available – reading and discerning the P&L statement becomes much easier. As a business owner, you can get a detailed financial analysis by comparing your company’s P&L statements over time.
You can prepare P&L statements on a weekly, monthly, quarterly and annual basis to determine the financial trends of your business over time. The P&L statements can help you assess whether your company is improving or deteriorating financially and assess future opportunities and challenges.
Learning how to analyze a profit and loss statement can be essential in making forward-looking decisions by assessing the revenue growth from a certain period to another. If you have introduced new products or services into the market, you can also get a clear picture of their profitability. These financial statements are also crucial in determining whether your company meets industry standards. All in all, understanding your P&L statements will ultimately help you determine if your company is on the right track – and if it is not, the P&L statement will help you make the corrective actions, with prospects for a better future.
As you have already learned, P&L statements are crucial to your company’s success and financial well-being. However, preparing, reading, understanding, and analyzing a P&L statement can prove to be an overwhelming, time-consuming task for you as a business owner. Working with a reputable accounting agency is highly recommended. One of the most reliable accounting agencies in Florida that you can turn to is Swiftbooks, LLC. Contact us at 786-204-2881 for consultation and a free quote on our services.