Does your business make or lose money? If you need to know the answer, tracking your small business's financial progress through a profit and loss (P&L) statement may be the answer to how your business is doing financially.
A profit and loss statement allows you to determine if your company is profitable and growing or if, on the other hand, it is losing money, and you need to make changes. In this guide, we will first define the main components of a profit and loss statement, then how to create your P&L step by step, and how you can use your report to assess your company's financial health.
So don't wait any longer; get complete control of your business finances!
What is a Profit and Loss Statement?
A Profit & Loss (P&L) statement, also known as an income statement, is a financial report that summarizes a company's revenues, expenses, and net income or loss over a specific period. You usually complete a profit and loss statement every month, quarter, or year.
A P&L provides a clear picture of a business's financial performance, helping you determine if your company is making a profit or incurring losses. Regardless of the size of your business, you must have a keen understanding of what these metrics are in your business to grow it.
A P&L statement enables you to identify areas where your business is performing well or struggling, allowing you to make informed decisions for improvement. A P&L statement can also be used as a baseline to produce a model for the future performance of your business.
As the adage says, you are what you measure. Having a "plan" with the same format as your P&L will allow you to benchmark your business costs and the performance of your business on any given month. That is precisely how we use it here at One Park Financial!
Key components of a Profit and Loss Statement
To fully understand and interpret a P&L statement, it's crucial to grasp its key components. Below we describe seven key elements of a basic P&L, which at its core, paint a comprehensive picture of your business's financial performance.
Revenue
Revenue is a company's total income through business activities within a specific period. It represents the money received from selling goods, providing services, or other sources related to the company's primary operations. To calculate revenue, you multiply the price at which the number of units sold sells a product or service.
Let's assume that your company manufactures and sells wooden chairs, and you sell 100 wooden chair units in a year for $50 each unit. The revenue from this product for that year would be:
100 units * $50/unit = $5,000
This $5,000 is your company's revenue from this product for that year. Note that it doesn't account for any costs or expenses the company incurred to produce or sell the product—those you would have to subtract later to determine net income or profit.
Cost of Goods Sold
Cost of Goods Sold (COGS) is the direct cost of producing goods a company sells. COGS includes direct labor costs involved in creating the goods and the cost of materials used. To calculate COGS, you can use the following formula:
COGS = Opening Inventory + Purchases During the Period - Closing Inventory
Let's break down each term:
Opening Inventory: This is the value of the goods available for sale at the start of the accounting period.
Purchases During the Period: This is the cost of additional inventory bought during the accounting period.
Closing Inventory: This is the value of the goods still available for sale at the end of the accounting period.
For example, if a company starts with $1,000 worth of inventory, purchases an additional $2,000 worth during the year, and ends the year with $500 worth of stock, the COGS for that year would be:
COGS = $1,000 (Opening Inventory) + $2,000 (Purchases) - $500 (Closing Inventory) = $2,500
Gross Profit
Gross profit, which you can calculate by subtracting the cost of goods sold (COGS) from total revenue, gives you a snapshot of your company's financial health. Think of it as a measure of how efficiently your company turns resources like labor and materials into revenue.
Here's the formula you'll use:
Gross Profit = Revenue - COGS
This figure is a fundamental indicator of your company's operational effectiveness. The higher the gross profit, the more efficiently your operation runs, or the higher the sales price you're achieving. On the other hand, a lower gross profit can point to inefficiencies, lower selling prices, or higher costs for goods sold.
The importance of gross profit can't be overstated. It serves as a critical indicator of your company's financial performance. Companies that maintain high gross profit margins tend to be more stable as they retain more funds to cover operating expenses, deal with unexpected costs, or reinvest for growth.
Operating Expenses
Operating expenses are the essential costs you pay to run and operate your business. Operating expenses can include a wide range of costs, such as:
Rent and utilities for office space.
Salaries and wages for employees.
Marketing and advertising expenses.
Office supplies and equipment.
Maintenance and repairs.
Depreciation and amortization.
Insurance.
Professional services, such as legal and accounting fees.
Taxes associated with operations.
To calculate operating expenses for a certain period, you add up all the above-mentioned non-production costs that the business has incurred during that period.
Operating Income
Operating income measures the profit a company generates from its core operations before interest and taxes. It excludes non-operating income, such as investment or interest expenses. To calculate your business operating income, you can use the following formula:
Operating Income = Gross Profit - Operating Expenses
The operating income provides insight into the operational efficiency of the company. The higher the operating income, the more profitable the company's core business operations are. If the operating income is low or negative, it may indicate that the company is not managing its operating costs efficiently.
Other Income and Expenses
Other income and expenses refer to the gains or losses a company experiences from activities not part of its core operations. This could include interest paid on loans (an expense), interest earned from investments (an income), gains or losses from foreign exchange, or income from selling an asset.
Let's assume that in one year, your company had:
Interest paid on loan: -$500 (This is an expense, hence negative)
Interest earned from investments: $200
Gain from selling a used company car: $300
The total of expenses for the year would be:
Interest Paid + Interest Earned + Gain on Sale = Other Income and Expenses
-$500 (Interest Paid) + $200 (Interest Earned) + $300 (Gain on Sale) = $0
So, in this case, the company's other income and expenses balance out to $0 for the year. If the result were positive, it would be considered other income; if negative, it would be other expenses.
Net Profit
Net profit, also known as net income or net earnings, is the amount of revenue left over after all expenses, taxes, and additional income and costs have been accounted for. It is a crucial measure of a company's profitability.
The formula for net profit is:
Net profit = Total Revenue - Total Expenses
Total revenue includes all income from a company's primary operations. In contrast, total expenses include all costs, such as the cost of goods sold (COGS), operating expenses, interest, taxes, and other expenses.
For example, if your total revenue for a period is $100,000 and your total expenses are $80,000, then your net profit would be:
$100,000 (Total Revenue) - $80,000 (Total Expenses) = $20,000 (Net Profit)
This calculation tells you how much profit your company has made after accounting for all revenues and expenses and thus reflects the final bottom line of your company for the given period.
Steps to Create a P&L Statement
After you gather all the relevant information mentioned above, to create a basic P&L manually for your small business, take the following steps:
Step 1: Start by calculating your gross revenue for the period.
Step 2: Calculate the Cost of Goods Sold (COGS).
Step 3: Determine Gross Profit (Subtract COGS from gross revenue)
Step 4: List Operating Expenses. Create categories for each type of expense. Don't include interest on business debt here; it will be accounted for later.
Step 5: Subtract the expenses (Step 4) from your gross profit (Step 3). This is your Earnings before interest and taxes (EBIT).
Step 6: List interest on business debt and subtract it from EBITDA (Step 5).
Step 7: List taxes on net income (which usually has to be estimated because a return typically has yet to be filed when preparing a P&L) and subtract taxes from the balance left in Step 6.
Step 8: List depreciation and amortization and subtract from the balance left in Step 7.
After completing Step 8, you have your very own P&L. Below, you can appreciate a picture of what a simple profit and loss statement template looks like:
The image above presents a snapshot of a Profit and Loss Statement, displaying key financial information that unveils the company's overall financial performance over a specific period.
Image source: Smartsheet
Remember that these steps will give you a simplified P&L statement. More complex businesses may need to account for more factors, such as depreciation, amortization, and changes in inventory, among others.
By comparing this P&L statement with previous years, the business owners can track performance, identify trends, and make informed decisions to continue growing their business.
Always consult with a financial advisor or accountant to ensure you track and calculate everything correctly.
How can you use your profit and loss statement?
To effectively analyze a Profit & Loss statement, it's crucial to read and understand its various components and metrics. Considering the following aspects, you can gain valuable insights into your business's financial performance.
Time-Based comparisons: Compare your Profit and Loss Statement changes in time to identify trends and understand the best periods for business profits. This analysis can help you plan for seasonality or other business factors impacting your company.
Industry benchmarks: Evaluate your P&L statement against industry benchmarks to see how your business performs relative to competitors. Benchmarking is the process of measuring your business performance by checking specific metrics. It can highlight areas for improvement or potential growth opportunities. You can compare your metrics against your direct competitors, other industries, and global averages.
Evaluate Cost of Goods Sold (COGS) and Gross Profit Margin: Review the COGS and the gross profit margin. If COGS rises faster than revenue, it could indicate rising production costs that you need to address.
If that's the case, analyzing your COGS and gross profit margin can help you look for areas in your production process that can be more efficient— streamlining processes, reducing waste, or investing in new technology or machinery to increase productivity.
Scrutinize operating expenses: Look at operating expenses and identify any trends or anomalies. If they're increasing faster than your revenue, it could indicate a problem. Conversely, if your revenue is growing more quickly than your operating expenses, it suggests increasing efficiency
Goal setting: The P&L can also help in setting and monitoring financial goals. Businesses can identify areas where they fall short and need action by comparing actual performance to budgeted amounts.
Investor and funder confidence: Regularly prepared and analyzed P&L statements can reassure investors and funders about the business's health, as it demonstrates that the company is being actively managed and monitored.
Unlocking financial success with expertise
For us at One Park Financial, it's a success when small businesses like yours thrive. Furthermore, implementing business tools like P&L is reserved for more than just large companies. Otherwise, it should also be part of the toolbox for all small business owners.
So, now that you're familiar with the critical components of a profit and loss statement, you know how essential it is to generate your report. The next step is to get to work and create your profit and loss statement. For this, we recommend that you contact a financial specialist, or you can also make your P&L statement using a profit and loss statement template.
Analyzing your metrics can help you optimize your business operations and invest in your long-term success. We hope this article has been helpful for you to start preparing a profit and loss statement for your business.
Disclaimer: The content of this post has been prepared for informational purposes only. It is not intended to provide and should not be relied on for tax, legal, or accounting advice. Consult with your tax, legal, and accounting advisor before engaging in any transaction.
