What is a Profit and Loss Statement?
Every new business begins with a few brilliant ideas. But you cannot create a successful business unless you flesh out your ideas in a business plan and then turn those ideas into action. From there, you can continue to develop new ideas to keep the business growing strong and prosperous.
However, you cannot neglect the financial side of running a business. Even though you may preoccupy yourself with your innovative business ideas, you still have to think about making money to keep your business afloat. That is why you must learn how to read and understand a critical business document called a profit and loss statement.
No business owner is expected to be their own accountant, but they must understand the basics of business finance and how certain decisions affect their company’s financial position. By learning how to read a profit and loss statement, you’ll be able to track your company’s financial status easily. Then you’ll know if your business decisions are paying off or costing your company a lot of money.
An Overview of a Profit & Loss Statement
A profit and loss statement outlines the financial status of your business by listing your company’s revenue and expenses within a specific period, such as yearly, quarterly, or monthly. It is an essential financial document you must regularly review to understand your company’s overall health and stability. Of course, you don’t have to create this document yourself because accountants possess the necessary skills and training to develop accurate profit and loss statements for business owners.
Think of a profit and loss statement as an income statement. Once the expenses are subtracted from the gross income, you will see the net profits earned if any. A negative amount of net profits would mean your company lost money during the specified period.
What is a Cash Flow Statement?
Another important financial document for managing your company’s finances is the cash flow statement. This document is different from the profit and loss statement because it focuses on the cash flowing into and out of your business regularly. It doesn’t concern itself with the net profits like the profit and loss statement.
After all, a substantial net profit on your profit and loss statement doesn’t necessarily mean you’ll have liquid cash on hand to pay essential business expenses, such as inventory and rent. Therefore, you need to know how much cash you have consistently flowing into the business each month to pay your bills. Otherwise, you could end up in a bad situation where you cannot pay your business expenses.
What is a Balance Sheet?
Profit and loss and cash flow statements have one thing in common: they outline your finances within a specific period. On the other hand, a balance sheet reports the current state of your finances rather than within a particular time period.
A business owner must have updated information on the current trend of their company’s financial accounts. The balance sheet features a detailed report of the company’s current balance between its assets and liabilities. Then you can compare the current balance sheet to past balance sheets to see if your liabilities continue to outweigh your assets.
What Information is on a Profit and Loss Statement?
A profit and loss statement outlines the net income generated over a specific time period. However, certain financial figures are included in the profit and loss statement that shows how the net income was calculated.
Here is what you can expect to see on a profit and loss statement:
The total revenue represents the amount of money generated from all your sales with customers. This amount usually goes on the upper section of the profit and loss statement.
COGS (Cost of Goods Sold)
The cost of goods sold refers to the expenses associated with producing the products sold, such as manufacturing costs and raw material costs.
Total Gross Profit
The total gross profit equals the total revenue minus the cost of goods sold.
Business Operating Expenses
The profit and loss statement categorizes your company’s various operating expenses. The total cost of goods sold isn’t included in this section. Instead, you’ll list the indirect and direct costs of operating your business.
For example, your direct costs represent the expenses for the continuing operation of your business, such as material costs and employee wages. Your indirect costs represent all other business-related expenses, such as monthly insurance premiums, power bills, lease payments, etc.
Net Operating Income
Net operating income equals your total income minus your total operating expenses. However, you don’t deduct depreciation, amortization, taxes, or interest from your net operating income. It’s simply there to show you how much your company has earned after deducting the standard operating expenses.
Some business expenses are not operating expenses but still require you to pay them. Some examples of these other expenses include income taxes, interest payments, amortization, and depreciation. These expenses must be included on your profit and loss statement as “other expenses.”
Net Loss or Profit
The last section of the profit and loss statement is for your total net loss or profit amount. You calculate this amount by subtracting all the company’s expenses from its total revenue. If the amount is a positive number, it means your company has made a net profit. But if it’s a negative number, your company loses money.
Understanding a Profit and Loss Statement
If you have never seen a profit and loss statement before, it can look overwhelming at first. All you’ll see is a bunch of numbers listed for revenue and expenses that will make your head spin.
One trick to better understand a profit and loss statement is to focus on the total amounts listed under each section. These sections include gross profits (total revenue minus COGS), operating expenses, non-operating costs (e.g., interest payments, income taxes), and net profits (or loss). And remember, the operating expenses section will have individual categories of its own.
Overall, you only really need to look at the top and bottom of the profit and loss statement to retrieve the most critical information. The top section shows your total revenue, while the bottom shows your net income (or loss). That is all you need to know.
Why is it Important to Understand a Profit and Loss Statement?
Many business owners focus too much on their initial business plan but not enough on their profit and loss statements. If you can understand your profit and loss statement, then you can understand the financial status of your company and whether it’s profitable or not.
You can make the necessary adjustments to your business operation based on the information in your profit and loss statement. For instance, if your business has too many operating expenses, you could find ways to cut those expenses in order to boost profits. Perhaps you could reduce your inventory or lay off employees to reduce expenses.
Get Professional Bookkeeping
Understanding where to find total revenue and total net profit (or loss) on a profit and loss statement is all you need to know. A bookkeeper or accountant can worry about all the other financial details and calculations on the profit and loss statement.
Do you need a professional small business bookkeeper to help you better understand your company’s profit and loss statement? Contact us to learn more about our services.