Of all the financial reports and statements that you need to run your business, the profit and loss statement is the single most important one. Not only does it show you the financial health of your company by summarizing all of your expenses and revenues, but it can also help you get financing, since investors and banks will want to see it when you apply for a loan or seek investment. It also comes in handy come tax time, since your accountant (or you, if you do your taxes yourself) will use it to file your taxes and determine what you owe. And if and when you decide to sell your business, prospective buyers will ask to see this statement as well.
As you can see, there are plenty of reasons why your profit and loss statement is so key in running your business! Now that you know how instrumental it is to the financial well-being of your company, let’s make sure you understand all the elements of it.
A P&L Statement By Any Other Name…
If the term “profit and loss statement” (or P&L, as the cool kids call it) isn’t familiar to you, you may know it under a different name, such as:
- Statement of profit and loss
- Income statement
- Income and expense statement
- Statement of operations
- Statement of financial results
Not to worry; all of these terms mean the same thing.
The Periods a P&L Statement Can Cover
You can generate your profit and loss statement for the quarter or the year, or can customize a date range for it. The quarterly statement tells you how things are doing right now, whereas the yearly view can give you a better sense of how expenses change throughout the year. You can recognize trends, such as revenue being much higher in Q4, or notice how you tend to have higher expenses at the start of the year.
Being aware of these trends can help you forecast and plan for the future. Maybe you decide to spread out some of those expenses you typically incur at the start of the year throughout the 12 months. Or maybe you set aside extra money in Q4 so you can easily cover the extra expenses in January.
Now Let’s Dive Into Categories
There are a few main categories in your profit and loss statement. The two large categories are income and expenses. But those break down even further:
- Cost of Goods Sold
- Various categories, like salaries, rent and utilities
And there are a few other terms in between we’ll walk you through. Ready? Let’s do this.
On the Income Side…
Under Income, you have an easy one: sales. This is how much business you did in a given period. So, for example, if you sold 100 dresses for $100 each this quarter, your sales would be $10,000. This is the dollar amount you received from your customers. Simple, right?
Then you have cost of goods sold. Essentially, this is what you paid for the goods that you sold. If you sell services, this won’t apply to you. But if you sell women’s dresses, you have a cost to buy those dresses before you sell them to customers. Let’s say a dress you sell for $100 costs you $50. Your cost of goods sold, assuming you sold 100, would be $5,000 for the quarter. While you won’t include administrative costs into your cost of goods sold, do account for any costs incurred in creating the product. If you buy dresses and then pay someone to modify them, include those labor costs.
To calculate your net sales, deduct any costs for returns or discounts on sales over that quarter. Then, to determine your gross margin or gross profit, subtract your cost of goods sold from your sales revenues.
That’s it for the profit side of your P&L statement. If you look at your gross profit number and think “how could I possibly be making that much?” stay tuned. We still have to take out all of your expenses.
Now We Move on to Expenses
Here comes the fun part! Taking money out of your business. On the expense portion of your P&L, you have a variety of types of selling and administrative expenses.
For selling expenses, you want to include any costs incurred either directly or indirectly in making sales. So advertising and marketing your business falls into this category, as do the salaries of any salespeople you hire. Shipping, too, is considered a selling expense (and not a cost of goods sold item).
For general and administrative expenses, calculate any and all expenses related to operating your business, not selling products. So office supplies, software, office rent, utilities and travel expenses are all examples of what would fall into this expense category.
It’s extremely important to properly categorize all of your expenses because many of them will be tax-deductible. That’s why having a category called “travel” rather than “2016 business conference” is imperative; your tax professional or accountant will quickly be able to match up your business expenses to IRS-approved expenses if they’re labeled the same.
The good news is that if you use an accounting platform, these categories will already be in the system and all you have to do is assign them to each expense.
At the bottom of your profit and loss statement, you’ll have your net profit. Here’s the math formula to understand how net profit is calculated:
Gross margin – selling and administrative expenses = net profit
So your net profit tells you how much money your company made after all expenses were paid. Don’t worry if the number is low, especially if you take owner’s equity out. You may even have a negative net profit, and that’s okay! As long as you are making more than you’re spending on selling and administrative expenses, it’s all good.
Review Your P&L From Time to Time
Get into the habit of reviewing your profit and loss statement monthly. By doing so, you can ensure that all of your expenses are being appropriately categorized (waiting until tax time will give you 12 months of knots to untie). You also can see which expenses are increasing and make decisions about whether you want to try to cut costs or not. You can stay on top of changes in revenues, too. If revenues are dipping, you might try a new marketing strategy or advertising somewhere new to boost sales.
In general, staying on top of your profit and loss statement (as well as your business finances in general) will help you be more informed about your business and help you make savvier strategic decisions that can help you grow your company.
What questions do you have about your profit and loss statement? Post them in the comment section below.