So, What is a Profit and Loss Statement?
The Profit and Loss Statement (P&L), also known as the Income Statement, is an important financial tool. It summarizes your company’s revenues (net sales) minus costs and expenses (i.e., Cost of Goods) incurred during a specific operating period. The statement is usually done quarterly or annually.
In other words, a P&L is a measurement of activity (revenue – expenses=profit) through time (whatever that operating period is).
A P&L is similar to a Balance Sheet, which is an important measure of Assets & Liabilities. But, the Balance Sheet is a measure of activity at a certain time.
Why You Need to Understand a Profit and Loss Statement
A profit and loss statement shows how well your business buys and sells inventory or services to make a profit. As you know, a company needs to create a profit in order to survive and grow.
If you analyze a profit and loss statement, you can determine your business’s cash flow that is available to repay existing debt, finance additional debt like loans in order to expand your business, or to reinvest in the business.
Mark Staniszewski, IndustriusCFO’s account manager says, “A business needs to keep good records of their financial happenings. It’s important for business owners to understand their expense structure and monitor these expenses to ensure they’re achieving a healthy Gross Margin and Net Income as measures of profitability. The old adage is ‘you could only improve what you can measure’ and compiling your P&L is the first step in measuring your company’s revenue minus expenses.”
In order to show you the positive impact a profit and loss statement provides, we’ve created a hypothetical example:
Once you understand where your business’s expenses are in relation to its revenue (typically done by having all expenses reflect a percent of total revenue (or Net Sales)) you could observe that perhaps your business’s Cost of Goods Sold (COGS) is 40% of Net Sales (NS).
Say your Gross Margin is 60% of NS. If you compare this to your industry peers, you may see that your COGS are more than your industry peers. Your peers are at 35%, with most disparity in Overhead.
So, you can conclude that you are paying more than your peers for Overhead. Then, you could begin looking at reducing these Overhead expenses, which will save money and increase your business’s profit.
How to Create a Profit and Loss Statement
You can do this with our eight simple steps!
1. First, list all of your Revenues minus any discounts in order tally up your Net Sales (NS) for a certain operating period like a fiscal year, for instance. This is the top line from which all expenses are deducted.
2. Second, if you are a manufacturing company, calculate your COGS. But, if you are a service company, calculate Cost of Sales. This includes Materials, Labor and Overhead directly involved with the manufacturing process. A service company will have Labor and Overhead, but probably not Materials.
3. Then, calculate Gross Profit, which is NS – COGS.
4. Next, deduct from Gross Profit even further by deducting Operating Expenses, such as Rent, Bad Debt (uncollected/uncollectable debt), Advertising/Marketing expenses, Salaries/Wages associated with employees not directly related to the production of the product (like managers, accountants, etc.), and Other Operating Expenses (computers, postage, etc.).
5. After Operating Expenses are deducted, you’re left with Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA). EBITDA is deducted from by Depreciation (reduction in value of tangible assets like machines) and if applicable, Amortization (reduction in value of intangible assets like patents), leaving Earnings Before Interest and Taxes (EBIT), otherwise known as Operating Profit.
6. EBIT (Operating Profit) is deducted from further by Interest Expenses (from all interest-bearing debt/loans/liabilities) and any Other Expenses, leaving you with Earnings Before Taxes (EBT).
7. Next, EBT is deducted from by Income Taxes, leaving Net Income.
8. Finally, Net Income is what a business is left with after all expenses!
We know you are passionate about your business and that you may not feel comfortable interpreting your monthly financial reports. But, we hope that these basic steps help you to understand how to create a Profit and Loss Statement.