A highly regurgitated piece of advice for small business owners is to monitor their finances. Veteran business owners are constantly urging their peers to always make sure their revenue and expenses are in good shape. Well, following this advice would be extremely difficult were it not for your profit and loss statement.
Also known as an income statement, your profit and loss statement is arguably a small business’s most important financial document. It provides a host of information related to expenses, revenue, profitability, and so much more. The combination of a profit and loss statement, balance sheet and cash flow statement makes up your financial statements, or your “financials.” These documents are essential for accessing small business loans.
Thanks to business accounting software, creating a profit and loss statement is fairly easy. Still, it’s crucial to understand the terminology featured in profit and loss statements along with how to draw meaningful conclusions from its plethora of figures.
In this guide, we’ll explain the information included in a profit and loss statement as well as why this information is so integral for improving cash flow and business growth.
What is a Profit and Loss Statement?
A profit and loss statement contains a business’s revenue, expenses, and net income over a certain period of time. Some businesses create monthly profit and loss statements, while others only do this once a year. Most businesses, however, create profit and loss statements every quarter. The information featured in a profit and loss statement can tell you which actions to take in order to improve your financial health and grow your business. This can include cutting expenses, making more sales, or ordering inventory at different intervals.
What is on a Profit and Loss Statement?
All and all, a profit and less statement is essentially a list of terms and corresponding figures. Some of these terms are very familiar, though others are a bit more complicated, requiring a series of calculations.
Here are the terms featured in a typical profit and loss statement followed by their definitions:
In addition to total revenue from sales, this refers to any money you receive and don’t have to pay back. Possible examples include money you receive from selling equipment or a tax refund.
This refers to the total amount of business expenses. There are other terms on a profit and loss statement that deal with business expenses, but this is the only one that asks for the grand total of them all.
Cost of Goods Sold (COGS)
The cost of all the resources required for producing a single unit is your cost of goods sold. This includes the cost of materials along with labor. The cost of goods sold is directly related to profitability, because a lower cost of goods sold = higher profit margin.
This section should not be confused with your gross profit margin, which is the profitability of a single product or service. Instead, simply subtract the cost of goods sold for a single unit from your revenue from a single unit.
For example, if you sell a product for $10 that costs $5 to make, the gross profit is $5. Your gross profit margin, on the other hand, would be 50%.
Operating Expenses (OPEX)
An operating expense is any expense required to run your business that is not included in the cost of goods sold. Examples include payroll, equipment, software, marketing, utilities, etc. Since this list can get pretty big, most profit and loss statements separate operating expenses into different categories.
Depreciation refers to the concept of goods losing value over time. In the small business world, depreciation can affect many types of equipment, from landscaping to health care. Business owners keep track of depreciation primarily to write off the losses of value on their taxes.
EBIT = earnings before interest and tax. To calculate EBIT, subtract operating expenses from your gross profit margin.
EBT = earnings before tax. To calculate EBT, subtract COGS, operating expenses, interest and depreciation from total revenue. EBT is widely used to compare the performance of two businesses, which can be difficult when taxes enter the picture because taxes can vary tremendously from business to business.
Earnings Available for Common Shareholders
“Common Shareholders” can refer investors as well as any business owner who takes a salary from the company. This section represents after-tax profits minus dividends from preferred stock. The resulting figure is the cut of the profits available for the business owner along with common shareholders, since the dividends for preferred shareholders have already been accounted for.
This is the portion of the business owner’s salary that is taken from the company’s revenue.
“Net income” is essentially another term for profit. Hence, calculating net income is as simple as subtracting all expenses from total revenue. It’s common for new businesses to arrive at a negative net income, or a loss. But if you don’t eventually turn that negative into a positive, your business may be in trouble. Net income is therefore the most important figure in the entire profit and loss statement. Luckily, there is always more you can do to improve profitability.
As you can see, some of the previous categories are very broad. Many businesses break the most general categories into subcategories to create a more granular picture of revenue and expenses. For example, your business might have multiple sources of revenue (i.e. in-store and online), or a large number of different materials for making products. In this case, you might want to create a separate category for “materials” and another for your total overhead (expenditures).
Subcategories also make sense when you have a particularly substantial expense that would otherwise be lumped into a broad category. Common examples include rent (instead of lumping this into operating expenses) and shipping (instead of lumping this into cost of goods sold).
Analyzing a Profit and Loss Statement
After calculating your net income, you may conclude that your company is highly profitable. But there is always more you can do to raise that number. As any experienced business owner knows, staying competitive means never becoming complacent.
For instance, your profit and loss statement might reveal a massive discrepancy between two revenue sources. You may find that one operating expense is eating up way more money than the others. Therefore, your company could increase profitability by improving the lower-performing revenue source and trimming that outstanding expense.
How to Prepare a Profit and Loss Statement
Preparing a profit and loss statement is much easier than analyzing it. Popular software tools like QuickBooks can automatically generate financial statements, including balance sheets and cash flow statements. Afterwards, all you have to do is run those numbers by your accountant to make sure they are accurate.
Plenty of business owners, however, still prefer to prepare a profit and loss statement manually. This isn’t much of a surprise since you don’t need much information to do so. So, if you’re not comfortable with accounting software just yet, here’s how to prepare an annual profit and loss statement on your own:
- Gather your business’s total revenue from each fiscal quarter.
- Do the same for your business’s expenses. Then, separate each expense into cost of goods sold or operating expenses.
- Calculate your quarterly or yearly EBIT by subtracting your total expenses from your gross profit.
- Calculate your EBT by subtracting all interest and taxes (over the course of a quarter or a year) from your EBIT. Producing an accurate interest timeline can be difficult. For that reason, it might be safer to have your accountant or finance professional calculate this number for you, or at least make sure it is correct.
- Now that you’ve gathered the most essential figures for your profit and loss statement, the final step is to calculate your net income. After all, the main purpose of this document is to determine if you are operating at a profit or loss.
Why Profit and Loss Statements are So Important
The value of a profit and loss statement stems largely from its convenience. This single document contains all of the most important figures for a small business. One look will tell you everything you need to know in regards to your business’s current state and the direction it is heading.
You could be raking in mountains of revenue or rapidly growing your customer base. But you won’t know if your business is truly successful until you look at your profit and loss statement and like what you see. Odds are, it will take a very long time to make that happen. How will you know if you are using the correct strategies? That’s right: Look at your profit and loss statement on a regular basis.