Very few small business owners have an interest in accounting.
But as everyone finds out, understanding the basics of accounting can be the difference between the success and failure of your company.
There are three particular financial statements that all small business owners should understand: balance sheets, cash flow statements, and profit and loss statements (P&L).
They all seem rather annoying and complex on the surface, but if you break them down one at a time, they’re pretty simple.
This post focuses on P&L statements.
By the end of this post, you’ll know 99% of all you’ll ever need to know about P&L statements. And you can download our free P&L template.
What is a Profit and Loss Statement (P&L)?
A P&L statement, also referred to as an income statement, measures your business revenue (income or sales) and expenses during a given time period.
Put another way, a profit and loss statement tells you whether or not your business is making money. Small business owners can use a P&L statement to assess business performance, identifying room for improvement and new strategies for growth.
It’s the “best tool for knowing if your business is profitable”, according to the U.S Small Business Administration.
Typically, a P&L statement is assessed over the following common time periods:
Some P&L statements are very simple to create and understand, as they are just a few lines.
Others can span pages.
It depends on the size of your business, and how complex it is.
A small business that only has a few sources of income or expenses will have a short P&L, while a large business with multiple income streams will have a longer one.
Finally, what does a “statement” look like? A P&L statement is essentially just a table, usually created in any spreadsheet tool (Excel, Google Sheets, etc.).
What Is The Purpose of a Profit and Loss Statement?
Ultimately, the purpose of a P&L statement is to calculate your net operating profit or loss.
If you make a profit, great! You can re-invest it, save it, or make a variety of other decisions. If you end up with a loss, it’s a clear signal that your business is on an unsustainable trajectory, and you’ll need to find a way to turn things around.
But on top of that, a P&L can be used to help you make informed decisions like:
- Can you afford to hire any new employees?
- Can you afford to move to a bigger office?
- How will you plan your taxes?
- Is your current growth strategy effective?
The P&L statement can also have additional uses depending on who’s looking at it.
Investors and Lenders
For example, investors will look at your P&L statements from multiple time periods to see how profitable your business is over time. They can also glean information about the efficiency of your operations, your competitiveness, and the soundness of your business model.
Lenders will look at P&L statements to determine whether or not your business is likely to make a profit in the future big enough to pay back loans and interest.
One last important note about P&L statements is that they do not represent your business’ financial health by themselves. They may reflect it in some cases, but they can be skewed (or misleading) by billing practices or fraudulent reporting of transactions (whether intentional or not).
That’s why it’s important to understand all three major financial statements that I mentioned at the beginning.
Understanding a Profit and Loss Statement
If it’s the first time you’re digging into profit and loss statements, parsing through these kinds of financial records can be daunting. There might be terms you’ve never seen before, so it’s useful to gain an understanding of what you’ll find in a profit and loss statement.
Fortunately, there are common line items that are generally included in most P&L statements. Understanding these concepts will help you put together, and analyze, profit and loss statements.
Let’s go through these terms one at a time.
All P&L statements start with a summary of revenue from sales that occurred during the given time period.
Usually, this is detailed in a separate table and the sum total is imported into the P&L statement.
There are different types of expenditure. Check our table as an example. Usually, more detailed P&L statements will drill down, offering detail into the type of expenditure.
There are many expenses that may be included, but it will vary widely for each individual business.
3. Direct Costs/Costs of Goods Sold
Direct costs (also referred to as the cost of goods sold) refers to costs that can be exclusively attributed to the production or sale of a product or service.
This includes the costs of materials used in manufacturing a product and any labor directly involved in that process. If you don’t manufacture the product that you sell, your direct costs would include the cost of purchasing it from your supplier.
Direct costs exclude all other labor and indirect expenses, such as marketing, accounting, internet service, training, rent, and insurance.
4. Gross Profit (and Gross Margin)
You can subtract direct costs from revenue to determine your gross profit.
Revenue — Direct Costs = Gross Profit
The gross margin is usually depicted as a percentage.
Use this formula to determine your gross margin percentage (also referred to as “gross profit margin”):
Gross Margin / Revenue = Gross Margin %
The gross margin is a key indicator of the financial health of your business and the soundness of your business model. The higher the percentage, the better.
Potential investors will quickly hone in on this number. This number also conveys information about how competitive your business is or can be in the near future.
5. Operating Expenses (OPEX)
Operating expenses (OPEX) are the costs of normal business operations
Operating expenses may include:
- Utilities such as phone and internet service
- Administrative costs
- Advertising (and other marketing)
- Office supplies
Depreciation is the reduction in the value of any of your business assets, like machinery or equipment.
Note that depreciation most commonly is an indirect expense, but depending upon the context, it may be a direct cost.
7. EBIT (Earnings Before Interest and Tax)
EBIT stands for earnings before interest and tax. It’s usually one of the last numbers on your statement. There are different EBIT formulas: a simple calculation is to subtract operating expenses and cost of goods (COG) from revenue.
8. EBT (Earnings Before Tax)
Earnings before Tax can tell you a lot about your business performance. Subtract COGs, OPEX, and depreciation from your total revenue to find EBT.
9. Net Income: Profit or Loss
Finally, you calculate the net income, by subtracting your indirect expenses from your gross profit.
This is your net profit — or loss — and the famed “bottom line” of the P&L statement.
You use this to determine if your business is profitable or not, and by how much.
This shows your business’s profit or loss. If you show a loss, it means you spent more than you earned. If you show a profit, it means you made more than you spent.
How to Analyze a Profit and Loss Statement
It’s hard not to be intimidated by your P&L statement. Even if you know the terms, how do you pull together the data to make any significant statements on business progress?
But it’s critical to analyze your profit and loss statements.
A detailed analysis of your profit and loss statement can reveal insights into your business performance, flagging strengths, and weaknesses. Plus, you can also use your profit and loss statement to compare your company against similar businesses and create industry benchmarks.
In fact, the US Small Business Administration suggests printing your P&L statement regularly to monitor business performance.
Performing a P&L Analysis
We’ve gathered some of the most effective ways to perform a P&L statement analysis:
- Year-on-year comparisons. Take a close look at drastic changes, e.g., drop in sales
- Studying trends. What’s the trajectory of your business? Are your strategies paying off? Comparing annual performance will help you determine whether revenue is growing faster than expenses, for instance.
- Projections. Consider using your P&L statement to help project future cash flows.
- Evaluating margins, e.g., gross profit margin
- Sales: study your standout months. Are there any particular drivers of success? For instance, did you double down on marketing, causing a bump in sales?
- Expenses. Are there ways to reduce expenses? What are the biggest expenses? Does this make sense for your business?
- Income. Are your income sources sustainable?
Examining these numbers can give you a good idea about the financial health of your business.
How Do You Prepare a Profit and Loss Statement?
By now, you might be ready to tackle your very own profit and loss statement. If you don’t feel ready to tackle it yourself, we highly recommend considering online accounting solutions like Quickbooks or Sage Business Cloud Accounting. Both can simplify the process and guide you through the steps we discuss below.
Here are some examples of the types of incomes sources and expenditure that go into these categories:
|Sales||Cost of Goods Sold|
|Fees for services||Rent|
|Interest on business loans|
To present the information, you have two main options.
First, you can pull together your own statement and create the document using a spreadsheet. Tools like Excel and Google Sheets have templates. We’ve created a simple profit and loss statement template for you to use here. Or, you can use small business accounting software like Freshbooks.
Either way, you’ll need the same data. And the best thing is, you should already have all the data you need.
Let’s have a look at the basic tips to build a profit and loss statement:
- Choose a time frame. Will you be assessing business progress monthly, quarterly, or annually? Keep in mind that short time frames probably won’t yield any meaningful data, e.g., anything less than a month. On the other hand, you don’t want to overwhelm yourself by digging into years and years worth of data.
- List your business revenue for the time period, breaking the totals down by month. Include your income sources, by month.
- Calculate your expenses. Separate direct costs like COGS from OPEX.
- Determine your gross profit by subtracting your direct costs from your revenue.
- Figure out if you’re making money. Subtract your total expenses from your gross profit. If you get a positive number, your business is on the right track. If not, you’ve identified the biggest problems holding your small business back. Use this insight to set your business on the path to profitability.
Downloadable Profit and Loss Template
Here’s a working profit and loss template complete with gross margin calculation built-in. Simply add your own numbers to the spreadsheet.
Profit and Loss Statement Examples
That’s really all there is to it, to wrap up let’s take a look at some basic examples.
The Simplest P&L Example
If you run a solo business with little diversity in revenue or expenses, your P&L statement might be as simple as this:
|Business Name P&L Statement – 2020|
The cost of goods sold was subtracted from the revenue to give a gross profit of $400,000.
The indirect expenses were then subtracted from the gross profit to reveal a net income (or profit) of $100,000.
A More Typical Real Life P&L Example
Most small businesses are a bit more complex than that.
Here’s what a more realistic P&L statement might look like:
I’ve used the same set of hypothetical data from the simple example to make it easy to see how they line up.
Those five main totals are all bolded, but the income, cost of goods sold, and expenses are all broken down into multiple line items.
There’s one final piece of terminology I’d like to point out in the example. Note that under income, there’s a line item labeled “Less: Returns.”
You will likely see “less” appear if you look up any other examples.
You can prepend “less” to items that are subtracted from the initial value in a section for clarity’s sake.
Frequently Asked Questions About P&L Statements
Believe it or not, that’s really all there is to P&L statements.
But even though you understand the core concepts, you may have a few specific questions still. I have answered the most common questions about P&L statements below.
Where are salaries and wages included?
Salaries and wages are the most confusing part of P&L statements. Salaries of people in administrative roles are not directly related to revenue, so they are included as fixed expenses.
It can get tricky when it comes to manufacturing roles. The labor used to directly make a product is included in the cost of goods sold section once the product is sold.
Are unsold inventory labor costs included?
The labor that went into the unsold inventory is not included in the cost of goods sold section. And yet, they are not a fixed expense either, so the labor that went into unsold goods is not included at all in your current P&L statement.
Instead, you’ll include it under the cost of goods sold when that inventory is actually sold, and before then, it’ll be tracked on your balance sheet.
What is the difference between a profit and loss vs income statement?
What is the difference between profit and loss and a balance sheet?
A profit and loss statement looks at whether or not your business is fundamentally profitable.
On the other hand, a balance sheet is another important financial report to report a business’ assets, liabilities, and shareholders’ equity. Combining the balance sheet with the P&L statement gives you a good overall snapshot of a company’s financial health.
What is a year-to-date profit and loss statement?
What’s the best time period to create P&L statements over?
Different people (you, investors, lenders) have different uses for your P&L statement.
As a business owner, you don’t necessarily need to create a P&L statement every month (but you can). What’s most important is that you’re checking if you’re on target to reach profitability at least once a month.
What is break-even analysis and how is it used?
Should you include interest paid on an annual basis in a monthly P&L?
Yes. Many loans have interest rates on an annual basis, so you’ll break down the amount of interest paid to add it to a monthly P&L.
For example, if you have a $100,000 loan at an annual interest rate of 12%, you’ll pay $12,000 of interest over the course of the year. Therefore, you’ll add $1,000 to a monthly P&L.
Where do you include large purchases or inventory on your P&L?
Inventory is not included in your P&L. Instead, it is tracked on your balance sheet as an asset.
What may be included in your P&L is any depreciation on inventory or large purchases, which, depending upon the context, may be included in your indirect expenses section or your direct costs section.
If all that makes sense, you know just about everything you’ll ever need to know about profit and loss statements for small businesses.
If you’d like to take your accounting basics further, learn how balance sheets and cash flow statements work.
Image 1 Source: Pixabay | rawpixel
Image 2 Source: Pixabay | geralt