Owning a company requires adopting a financial responsibility to strategize ways in order to make a profit, even when business is not going well. The easiest way to do this is by creating profit and loss (P&L) statements. In fact, all businesses of any size must maintain a profit and loss statement.
The three main financial statements every small business owner should use. These are P&L statements, cash flow statements, and the balance sheet, respectively. Profit and loss statements, or P&L statements, show where revenue is earned and where all your money is spent.
P&L statements assist small business owners to understand how the business is doing in a specific time period. Such statements are also important for business milestones, such as a physical review of the company when inquiring with an investor.
If you want to understand when profits lost and gain, read on and find out everything about these statements.
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Profit and Loss (P&L) statements are often known by various names. There are different ways to identify P&L statements.
A large number of professionals, entrepreneurs and investors call the P&L statement an “income statement” in common business terms.
If you are not used to reading financial statements, the P&L statement can be a bit overwhelming at first glance. Unlike the balance sheet, a P&L statement displays income and expenses over a specified period of time — usually monthly, quarterly, or annually.
Profit and loss statements can be classified into three main sections: revenue, cost of sales and operating expenses. Let us use the example of a consulting agency, to break down the sections of a P&L statement, as well as the key metrics to pay attention to.
The revenue section shows money to bring into the business over a specified period of time. This section refers to the “top line”. For businesses that use the accrual method of accounting, the revenue section will include all recognized revenue for a given time period — including invoices that have been sent even if the cash has not yet been collected.
The cost of sales (COS) section reflects money spent on delivering products or services. Second way to think about COS is direct cost inputs into generating revenue. Sometimes, the cost of sales refers to the cost of goods sold (COGS), depending on the business type.
These terms are using interchangeably in accounting, though there are a few exceptions. The cost of sales is a variable, meaning it changes in relation to revenue. If the cost of sales increases, revenue should increase, too. If revenue increases you can see an increase in the cost of sales section of your P&L statement. The cost of sales is crucial for calculating gross profit.
Not sure if an expense ought to be considered a cost of sales? Ask yourself, “If I stop paying this expense, Will I still generate revenue?” If the answer is no then the expense is likely a cost of sales.
The expenses account for money spent running the business day-to-day. Essentially, everything that is not revenue or cost of sales. It is the expenses such as rent, office supplies, or insurance and it is important for the business to function properly.
Let us take an example of a consulting agency. They rent an office that is equipped with telephones, internet, and other basic office supplies. They pay their employees well enough for their great work and employ a few contactors. All of these items allow the business to function and assist in generating revenue, therefore they belong in the operating expenses category.
(d) Other Income and Expenses
Revenue, cost of sales and operating expenses are the three main sections of an income statement. Sometimes, there are other expenses that do not quite fall into the operating expenses bucket, for example, taxes. These items are typically not recurring transactions but are, in fact, costs of doing business. These other expenses may show up an income statement depending on the time period in review. When they do, they are accounted for under “Other Income and Expenses” in the profit and loss statement.
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Let us take a look at the various metrics that we use on a profit and loss statement.
Gross profit refers to how much money is on hand to run the business. It is the first health test for your business that you can find on the income statement. To calculate gross profit, subtract the total cost of sales (or cost of goods sold) from the total revenue. Gross profit, sometimes known as gross margin, should be a positive number indicating money available to cover operating expenses and still make a profit.
Think of gross profit this way: once total revenue and the must-pay costs (cost of sales) is removed, how much money is left over?
Let us take the example of a consulting agency in this scenario. Looking at their monthly P&L statement, they brought in $191,114.87 in total revenue and spent $105,181.58 in the cost of sales for the month, giving them a gross profit of $85,933.29.
The formula for calculating gross profit is:
Gross Profit = Total Revenue – Total Cost of Sales
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Net income is the total incoming revenue subtract from the cost of goods sold and all other business expenses. Consider the net income as the percentage of total revenue. Net income refers to as the “bottom line” because it lives in the bottom line of the P&L statement. The formula for calculating net profit is:
Net Income = GP– Operating Expenses – Other Incomes and Expenses
Income Statements indicate Profits Gained and Loss for a Period of Time
Income statements can tell a lot about the amount of revenue gained and lost in a specific time period. Small business owners can look income statements monthly, quarterly, or yearly depending on their business size, health and needs. You are not limited to creating one P&L statement per time period. If you would like to make yearly income statements and compare them to previous years, you can still make quarterly or monthly statements to view your profits gained versus profits lost.
Creating a P&L statement every month will give business owners timely updated information that they can use to run their businesses. Producing additional annual statements can help to supplement those monthly reports and ensure the business is on track to meet long-term goals.
P&L statements can show you much more than simply the amount of money you made and the amount of money you lost. Use your income statement to identify how much you are spending and other necessary business expenses that cut down on profit. The P&L statement also displays any changes made to your accounts, such as a new business checking or savings account. You can also compare your income statements to your bank account and credit card systems to determine if you are spending too much or if you are in any credit card debt.
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When you are looking at the P&L statement for your small business, start with the top line to understand your revenue. Most business owners and managers have a sense of what they are expecting to make in a given time period. Use your top line to measure your goal for the given time period.
Next, head down to the bottom line to see if you were able to cover all expenses and make a profit. If there is something you do not expect, do some findings. Have a net loss? Check out your gross profit first. Your gross profit could be positive and still equal to a net loss for a given time period.
If that is what your income statement shows, check to see if your gross profit was lower than the previous reporting period. If it is, that means you did not have quite enough to cover operating expenses for that time period. Dig into your operating expenses to see if you spent more, or if there are any uncommon fluctuations. In other words, do not discount it as a bad month and move on. Go in-depth to find out more.
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P&L statements are used to review a company’s profits and are compared to past statements to determine if any decisions need to be made to cut down on costs or strategize ways to increase revenue. While reviewing these statements, you may decide to cut down on staff.
You can decide to buy materials from a different company or cut down on other expenses such as downgrading your office. If you make a profit, you can find ways to increase your profit even further. You can also make other decisions like hiring, upgrading equipment and offering more benefits for your employees.
The successful P&L statement campaign combines the strategy of driving revenue while cutting costs.
Many businesses look for investors at some point in their growth. Since investors typically use their own money to help capitalize on your business, they will want to make sure their investment is worth it. When they calculate the strength of your business, they will look at your P&L statements. Some only look at your yearly statements, while others may request your quarterly or even monthly statements.
Businesses have to pay both quarterly and yearly taxes, and the amount they owe depends on their filing status and the amount of revenue they claim. If you are not sure of the amount of revenue you should claim, having an updated P&L statement will help when filing your taxes can be helpful. P&L statements also assist your accountant or tax preparer. Be sure to submit your income statements to them, as well as the statements for the previous year.
While P&L statements are necessary for any business owner, all businesses come in different shapes and sizes. The CEO of a large corporation will often look at a very different statement from a small business owner who sells artwork part-time. The key factors of a profit and loss statement are documenting profits and losses in a certain amount of time. All business owners ought to document all profits and losses, the amount of time to document them is flexible.
For instance, the corporate CEO needs to document statements at least quarterly. He or she probably has several expenses such as a mortgage on an office and a lease on a warehouse and a large staff expanding multiple cities. On the other hand, the part-time artist might only need to make their statements once a year. This will help determine how much sales they are receiving alongside small expenses they need to pay.
The answer is simple. If you own a business, then you will need to make a profit and loss statement. You may not think it is necessary since a P&L statement is not usually required by the IRS, your business filing, or any other significant form. So it is easy to overlook the necessity of this statement.
Many medium-to-large size companies know how the importance of a P&L statement is (and in some cases are required to create one) but it can be difficult for a small business or sole proprietor to understand why they should make a P&L statement.
If you are not generating a large revenue and have small business expenses, then what is the point? But, what if you want to reach out to an investor or an accountant? Or you are applying for a business loan? What if you just want to make smart decisions about how to grow your business? These are just some of the questions which we can’t ignore.
This is why it is important for all businesses, big or small, to get in the habit of creating P&L statements. Even if your small business is not generating any sales, a profit and loss statement will show any expenses you are making to sustain the business and can even give you an insight on marketing efforts in order to start gaining revenue.
Making an income statement may seem intimidating, but it is easier now than ever. As long as you are keeping financial records of all earnings and expenses, you can easily create and read your income statement.