Understanding P&L Statement
Many small business owners find themselves in a position where they are unsure how to analyse their profit and loss statement. The following post will offer an introduction to this topic, as well as some helpful tips for interpreting your P&L.
The most important thing when you’re reading a profit and loss statement is that it’s not one-size-fits-all. Every business has different costs associated with running the company, which means that there is no right or wrong way to read the numbers on your own P&L statement. Some of the things you’ll see on your P&L are fixed costs (the same every month) while others are variable costs (costs that change each month).
The balance sheet, cash flow statement and profit and loss statements are three of the most important financial statements that a business can issue. The profit and loss report also called income statement is one of these major reports which reviews what it actually means for businesses in terms of revenue, expenses based on operation data.
This blog won’t discuss how to create a profit and loss statement but rather analyses the importance of having the statement for your business.
If anything you should at least be using an accounting software to record all your business transactions. The software could then produce the necessary financial statements on demand not relying on manual calculations. So make use of technology and automate as much as possible. Understanding why you are doing what you’re doing would help you be mindful of your business health.
In short, a P&L statement is a report of income and expenses incurred during an accounting period. This can be for a month, quarter or a year.
Cash vs. Accrual Basis
When analysing a P&L, take note of if they are on cash or accrual basis accounting method.
For a cash basis, income and expenses are reported when money exchanges hands. For example, we entered a phone bill on 14th June and paid it on 30th June. The accounting system recognised the expense on 30th not on 14th when we recorded it.
Whereas the accrual method accounts for the amounts as soon as earnings and expenses happen before money changes hands.
Be aware of the accounting method the software is using when generating the report.
What should a profit and loss statement include?
Example below shows a P&L of a fictitious company based on Accrual Basis, for the month of July.
The bolded headings are the major categories of the P&L report.
Though they may be presented differently, all P&L show a company’s revenues and expenses over a particular period of time, providing information about the performance of the business. The followings are the major categories of the report:
1. Trading Income: This is how much money your company made from selling things in the accounting period. It includes the money you earned from your main business and any business assets you sold.
2. Cost of Sales: The direct costs associated with buying or producing a product or providing a service.
3. Gross Profit: Also known as gross income or gross margin. It’s the trading income deducting costs of sales.
4. Operating Expenses: These are the money used to pay for things that are needed to operate the business, like rent, utilities, payroll, and other necessary costs.
5. Net Profit: Although the report says Net Profit, we prefer to refer to it as Operating Income.
6. Net Profit/Loss: This category is not shown in the report above. It’s The Profit Or Loss that remains after all expenses and costs have been subtracted from revenue. It’s the amount after taxes, depreciation, interest and authorization.
A common question we’ve seen: “Is Interest Expense an Operating Expense?”
Interest expense is not an operating expense. A non-operating expense is an expense that isn’t related to a business’s key day-to-day operations. Operating expenses include rent, payroll or marketing, for example. Therefore interest expense is deducted after operating income.
For example, a small electrical company would need to pay its staff and bookkeeping work as part of its day-to-day operations. Paying a bank loan is not directly part of the business’s operations.
The P&L report shows GST exclusive values, as the GST is allocated to the GST accounts when transactions are recorded. Remember P&L reports income and expenses but GST is neither an income nor an expense. It is allocated to a liability account. The Balance Sheet report displays all the asset, liability and equity accounts.
In the case you’re not registered for GST then GST on your purchase becomes an expense as you can not claim GST.
What can an income statement tell you about a company?
By just analyse a profit and loss statement above alone, we could tell a lot about the business. The Cost of Sales (Purchases) is a fairly small percentage of the Sales which could indicate that it’s a service based business.
The three major operating expenses in this scenario are Advertising, Legal Expenses and Wages and Salaries. As a business owner, you’d like to know:
Why are they high?
Are the figures justified?
Can they be reduced in the near future?
Was the advertising campaign effective? What was the return on investment (ROI)?
Should we continue running the ads? Is there an alternative? What are the different mediums/platforms we could test on?
Legal expenses may be a once off cost, so it would not affect the bottom line as much.
Have we achieved the objective of the legal avenue?
Why is the figure for wages and salaries at this level? Are we over or under-resourced? If we’ve more manpower, how can we increase revenue?
These are just some of the many questions we could look into.
By not knowing anything else about the business, a trained bookkeeper can delve deeper into the business operations for further improvements.
Profit and Loss Report should be looked at along with Balance Sheet and Cash Flow reports to truly understand the business activities from a management perspective. Business is about serving customers and tracking numbers.
We must know what to measure in order to track our progress.
Your business structure will determine how some expenses are calculated. Your accountant can provide detailed advice regarding your structure.