Small and medium-sized businesses (SMBs) often fall into a unique financial management situation. Many are too small to have thorough financial reporting practices in place, but they’re also too big to make sense of their financial data without accurate reporting. In the United States, 41% of small business owners manage their own accounting and financial processes.
Sustained success in this middle ground requires mastering the nuances of financial management, beginning with the profit and loss (P&L) statement.
Your P&L statement is a simple yet powerful financial reporting tool that not only highlights the current financial position of the business but also charts a course for the future. Think of it as a financial compass; it guides entrepreneurs through their revenue and expenses, enabling them to make informed decisions that can define the fate of their businesses.
For the many small business owners working to improve their financial health and performance, this is your go-to guide for all things profit and loss.
TL;DR
- 41% of small business owners manage their own accounting and financial processes. P&L statements help them understand their business through their financial data.
- P&L statements dive deeper into the business finances to uncover valuable insights that reveal strengths and weaknesses.
- When regularly reviewed, P&L statements are like a consultant in a spreadsheet, identifying trends in revenue, expenses, and profitability over time.
Basics of the Profit & Loss Statement
Also known as an income statement, the profit and loss statement is a financial document that provides a snapshot of a business’s revenues, costs, and expenses over a specific period of time. It is used by businesses of all sizes, as well as investors and analysts, to track an organization’s financial performance.
Here is the basic structure of a profit and loss statement:
- Revenue
- Cost of goods sold (COGS)
- Gross profit
- Operating expenses
- Operating income
- Other income and expenses
- Net Income.
This information can be pulled from accounting software like Quickbooks if it is up to date with transaction data from sources like your payment platform provider.
Breaking Down the P&L Statement Template
Revenues/income
The revenues and income section outlines the gross revenue generated by the business during the specified reporting period, typically 12 months. This includes sales, services, and any other sources of income, such as interest or rental income. It also includes the net revenue after accounting for certain deductions, such as returns, allowances, and customer discounts.
Cost of goods sold (COGS)
The COGS section represents the direct expenses incurred by a company in producing or purchasing the goods it sells during a specific period. It includes costs like raw materials, direct labor, and manufacturing overhead. The COGS calculation involves adding the opening inventory to the purchases made and subtracting the closing inventory. For manufacturing companies, COGS comprises raw materials, direct labor, and manufacturing overhead costs.
Understanding COGS is pivotal to determining a company’s profitability, especially its gross profit margin. The gross profit margin, calculated by subtracting COGS from revenue and dividing by revenue, indicates how efficiently a company produces or acquires its products. A higher gross profit margin reflects effective cost management, enhancing the company’s financial health.
Gross profit
Gross profit is calculated by subtracting the COGS from the total revenue. It reflects the profitability of the core business operations before accounting for other expenses.
Gross profit indicates how efficiently a company can produce or acquire its products. A higher gross profit signifies that the company retains more money from sales after covering the costs directly associated with production. This surplus can be used to reinvest in the business, cover operating expenses, or pursue strategic initiatives.
Operating expenses
Operating expenses include all costs not directly tied to producing goods or services. Within this category of the P&L report, there are different sub-categories: selling, general, and administrative expenses (SG&A).
Selling expenses cover costs related to sales, like marketing and salesperson salaries. General expenses include administrative costs like office supplies and utilities, while administrative expenses involve management salaries and other administrative functions.
Additionally, there are non-cash operating expenses like depreciation and amortization. Depreciation accounts for the decrease in the value of physical assets over time, while amortization applies to intangible assets’ gradual reduction in value, like patents or copyrights. Although depreciation and amortization don’t involve actual cash outflows, they are important for accurate financial reporting as they represent the wear and tear of the company’s assets.
Categorizing and reporting operating expenses helps owners pinpoint areas where cost-saving measures can be applied, ensuring sustainable profitability.
Operating income
Operating income, or operating profit, is calculated by subtracting the total operating expenses from the gross profit. It indicates the business’s profitability after accounting for the cost of goods sold and operating expenses. Operating income excludes non-operating items such as interest and income taxes, providing a clear picture of the profitability directly related to the company’s day-to-day activities.
Operating income is a key metric for evaluating operational efficiency and management effectiveness. A healthy operating income indicates that a company is generating profit from its primary business activities.
Other expenses and income
The “Other Expenses” and “Other Incomes” sections account for financial activities beyond the core operations of a business.
Other expenses include:
- Interest expenses: These are costs incurred due to interest payments on loans or credit facilities.
- Income tax: This includes taxes paid on the company’s earnings.
- Non-operating losses: Losses from activities not directly related to the business’s core operations, such as losses from expenditures, such as investments or asset sales.
- One-time expenses: Unusual or exceptional expenses that are not expected to recur regularly, like legal settlements or restructuring costs.
Other Incomes:
- Interest income: Income generated from interest on investments, savings accounts, or other financial instruments.
- Non-operating gains: Gains from activities not central to the business, like profits from the sale of assets.
- One-time incomes: Irregular or exceptional incomes not part of regular operations, such as insurance settlements or legal judgments in the company’s favor.
Including these items in the financial statement provides a comprehensive view of a company’s financial performance. That’s because these components not only affect core business activities but also external financial events and decisions.
Net income
Net income, also known as net profit or the bottom line, is the residual profit a company has after deducting all expenses, taxes, interest, and other financial activities from its total revenue. In essence, it is the P&L—it represents the company’s profit or loss for a specific period and is a key indicator of its overall financial performance.
Calculated by subtracting all operating expenses, interest, taxes, and other non-operating expenses from the gross profit, a positive net income indicates that the company is profitable, while a negative net income signifies a loss (a.k.a. a net loss). This section shows the complete picture of overall profitability and financial viability.
Accrual vs. Cash
There are two P&L reporting methods that businesses should be aware of:
Accrual method
Revenues and expenses are recorded when they are earned or incurred, regardless of when the cash is received or paid. The accrual method is what’s used in the Generally Accepted Accounting Principles (GAAP), a standardized guideline for accounting and financial reporting. Public companies will always use the accrual method.
Cash-based method
Transactions are recorded only when cash is received or paid out. Revenues are recognized when the payment is received, and expenses are recorded when they are paid. Small businesses, freelancers, or sole proprietors with straightforward operations may opt for cash-based accounting due to its simplicity and ease of use.
Generally, if businesses have multiple revenue streams and total expenses are beyond single salaries and business operation basics, accrual is the best method.
P&L in Practice
Let’s look at the role of a P&L statement for a small furniture manufacturing company at the end of the fiscal year. With the P&L statement in hand, covering the 12 months prior, the business owner can review the document and see what valuable insights are within it that will help inform strategic decisions for the upcoming year. Here’s what they can assess, identify and achieve:
Revenue streams
From the P&L statement, our manufacturing business finds that the most significant portion of the company’s revenue comes from customized office furniture contracts with local businesses. This insight prompts them to hone their marketing efforts, specifically targeting local businesses.
Viability of current cost of goods sold (COGS)
Through the COGS section, the company can see that the cost of their high-quality wood has increased over the last fiscal year. This affects their profit margins. The business now knows that it’s time to look at alternative wood suppliers and negotiate better rates to ensure their production costs remain competitive without compromising on quality.
Anomalous operating expenses
The P&L statement breaks down operating expenses, including salaries, marketing, and utilities. The management team notices a spike in marketing expenses during a specific quarter. After further investigation, they found that the increase was due to a one-time marketing campaign. With this insight, they analyze the campaign’s effectiveness to determine if similar initiatives should be repeated in the future.
Context within profitability and net profit
Fortunately for the manufacturer, the bottom line of the P&L statement shows a healthy net profit for the year. However, compared with the previous year, the net profit margin has slightly decreased. To address this, they strategize ways to optimize operational efficiency by investing in better machinery or training for their staff to enhance productivity.
Reporting accurate information and insights to stakeholders
Armed with the insights from the P&L statement, the company prepares comprehensive reports for stakeholders, including investors and lenders. These reports showcase the company’s financial performance, highlighting areas of strength and strategies for improvement. Transparent communication based on P&L insights helps build trust and confidence among stakeholders.
Enabling strategic future planning
With a clear overview of their financial standing, the business owner can begin strategic planning sessions. They set goals for the next fiscal year, aiming to increase revenue from new customer segments, optimize expenses, and enhance overall profitability. The insights from the P&L statement served as a foundation for these strategic decisions, guiding the company’s trajectory for the upcoming year.
Analyzing P&L Trends Over Time
As our manufacturer proves, P&L trend analysis is a powerful tool for evaluating a company’s financial performance and identifying patterns and fluctuations in revenue, expenses, and profits. By comparing P&L statements from multiple accounting periods, you can discern trends, both positive and negative, that indicate your financial trajectory. This information allows you to spot cost-cutting, revenue-enhancing, and risk-minimizing opportunities.
Cost-cutting
Cost-cutting opportunities can be identified by analyzing the statement of operations. Look for areas where expenses have increased disproportionately to revenue growth or areas with high operational costs compared to industry standards. Common targets include inefficient processes, unnecessary overhead, or overspending on marketing without adequate returns.
Revenue-enhancing
Look for patterns in revenue growth, customer segments contributing significantly to sales, or successful product line items/services. The P&L statement can also help identify underutilized assets, untapped customer segments, or successful products that can be further promoted or diversified.
Risk minimization
Risk assessment and minimization can be done by analyzing various expense categories and assessing their potential vulnerability to economic fluctuations, market changes, or internal challenges. For example, high dependence on a single supplier for raw materials (such as in our manufacturer’s example) poses a supply chain risk. Similarly, excessive debt leading to substantial interest expenses can be a financial risk.
The Bottom Line on Your Bottom Line
The profit and loss statement is one of the most valuable internal documents a business possesses. It’s accurate information, based entirely on the company’s own financial data, that reveals where the strengths and weaknesses lie. It’s a consultant in a spreadsheet, identifying trends in revenue, expenses, and profitability over time.
Businesses that utilize this information regularly over time have more control over their success. They set a path for continual improvement. They are better placed to secure investments, and they have the insights to light the way in adapting to changing market dynamics. P&L savvy businesses move forward fully informed, priming them for long-term success.
Request a QuoteFAQs about Profit and Loss Statement
Q: What is a Profit and Loss (P&L) statement?
A Profit and Loss (P&L) statement, also known as an income statement, is a financial report that provides a snapshot of a business’s revenues, costs, and expenses over a specific period of time. It is used by businesses, investors, and analysts to track an organization’s financial performance.
Q: What is the significance of a P&L statement for small and medium-sized businesses (SMBs)?
A P&L statement is a crucial financial reporting tool that highlights the current financial position of the business and helps chart a course for the future. It guides entrepreneurs through their revenue and expenses, allowing them to make informed decisions that can define the fate of their businesses.
Q: What are the basic elements of a Profit and Loss statement?
The primary components of a P&L statement include Revenue, Cost of Goods Sold (COGS), Gross Profit, Operating Expenses, Operating Income, Other Income and Expenses, and Net Income.
Q: How does a P&L statement help reveal the strengths and weaknesses of a business?
A P&L statement dives deep into business finances to uncover valuable insights. By regularly reviewing these statements, business owners can identify trends in revenue, expenses, and profitability over time. This information can be used to optimize operations, cut costs, and boost profitability.
Q: What is the difference between accrual and cash-based P&L reporting methods?
In the accrual method, revenues and expenses are recorded when they are earned or incurred, regardless of when the cash is received or paid. On the other hand, in the cash-based method, transactions are recorded only when cash is received or paid out.
Q: How can businesses leverage insights from the P&L statement for strategic planning?
By analyzing their P&L statements, businesses can pinpoint areas of strength and weakness, identify trends, and make informed decisions about future operations. These insights can guide strategic planning, goal setting, and operational optimization.
Q: What role does a P&L statement play in stakeholder communications?
A P&L statement provides comprehensive information about a company’s financial performance. Businesses can use this data to prepare detailed reports for stakeholders, including investors and lenders, highlighting areas of strength and strategies for improvement.
Q: How does a P&L statement help in identifying cost-cutting, revenue-enhancing, and risk-minimizing opportunities?
By comparing P&L statements from multiple accounting periods, businesses can identify patterns and fluctuations in revenue, expenses, and profits. This information allows them to spot opportunities for cost-cutting, revenue enhancement, and risk minimization.
Q: What does the net income in a P&L statement indicate?
Net income, also known as net profit, is the residual profit a company has after deducting all expenses, taxes, interest, and other financial activities from its total revenue. It represents the company’s profit or loss for a specific period and is a key indicator of its overall financial performance.
Q: How does a P&L statement contribute to long-term business success?
Regularly reviewing and utilizing the information from the P&L statement allows businesses to control their success more effectively. They can set a path for continual improvement, secure investments, and adapt to changing market dynamics, thereby priming themselves for long-term success.
