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Understanding your Profit and Loss statement

The Profit and Loss statement offers you an important means of monitoring the progress of your business so it's important that you understand how it works. This guide offers a simple explanation of its structure and how you can use the Profit and Loss statement to better manage your business.

What is a Profit and Loss Statement?

The Profit and Loss (P&L) statement and the Balance Sheet are the major financial documents most familiar to all small business people. Of the two, the Profit and Loss statement is easier to understand because its format is simpler. The related article Understanding your Balance Sheet should be read in conjunction with this guide.

It’s sometimes referred to as an income and expenditure account or a statement of financial performance.

Whatever it’s called, its main purpose is to list all your income and expenses, and the difference between the two – which is your profit or loss.

It usually shows the figures for this year and last, so it’s a great way to compare performance over time.

How often is it produced?

Every business produces a P&L at least once a year for their annual tax return, as well as a balance sheet.

But with modern accounting software you can produce them at the click of a button – and producing quarterly or even monthly P&Ls can help you spot trends and take action to address them earlier.

For example, you may notice that certain expense items have increased significantly since the previous P&L statement. So a quarterly or monthly P&L statement is of more use to you than a yearly account.

Structure of the Profit and Loss Statement

Here's a typical example:

Acme Furniture Company Ltd
Profit & Loss Account: 2018 Tax Year
    2016 2017
Sales $190,000 $135,000
Less: Cost of Sales - These are the direct costs of producing your goods or services, eg if you make wooden garden furniture, the cost of timber, glue, paint and screws but not the cost of running your website or paying staff. Many service businesses won't have any Cost of Sales because they sell only time – they don't buy in raw materials.    
  Production expenses $35,000 $25,000
  Postage and packaging $3,500 $2,000
Total cost of sales $38,500 $27,000
Gross Profit $151,500 $108,000
  Other income $2,500 $570
  Interest received $1,250 $895
Gross income $155,250 $109,465
Less: Expenses - -
  Accountancy fees $1,250 $1,190
  Bad debts $500 $250
  Electricity $1,200 $1,180
  Telephone $1,450 $1,400
  Vehicle expenses $7,500 $4,650
  Office expenses $12,560 $12,200
  Depreciation $3,245 $3,680
  Shareholders salaries $60,000 $55,000
Total Expenses $87,705 $79,550
Net Profit (before tax) $67,545 $29,915

Direct costs and fixed costs

Two lots of expenses are deducted from the income of the business. In broad terms, these two categories are:

  • The direct costs of producing your goods or services. These are categorised as Cost of Sales or Cost of Goods Sold (CoGS). For example, if you make wooden garden furniture, you have to buy in timber, glue, paint, screws, etc. Note that many service businesses (such as a financial consultancy, for example) won't have any Cost of Sales or CoGS, because they sell only time: they don't buy in raw materials to process and sell.
  • The fixed expenses (or overheads) of running your business.

These two categories contain totals that are assembled from your financial records. For example, the Office Expenses total might include a variety of expenses such as stationery, tea and coffee, stamps, etc.

Why are these two expense categories separated?

Separating these two cost categories enables you to monitor the performance of your business more effectively. This is because the first category is variable, the second is fixed.

The Cost of Sales is a variable expense because it will vary according to sales. If you sell more chairs, you'll need to buy in more raw materials. Separating out these costs allows you to keep an eye on the ratio between Sales and Cost of Sales. The lower you can keep your Cost of Sales in relation to Sales, the more profitable your business is likely to be. For instance, if the price of timber rises markedly because of shortages in the market, you'll notice your Cost of Sales increasing in relation to sales. This should prompt you to take some remedial action such as raising your selling price to compensate for the increased cost of your raw material.

The second category of expenses is referred to as Fixed expenses because the expenses represent the relatively fixed costs of running your office and business premises - your overheads. Whether you manufacture one chair or 1,000 chairs, you still have the costs of keeping your business open. You have to pay rent, electricity, telephone and other office overhead costs. Nevertheless you want to keep an eye on your fixed expenses (or office overheads) as a percentage of total sales. For example, if it costs you $20,000 to run your office, and your sales are $200,000, your fixed expenses represent 10% of sales. If you can increase your sales next year to $300,000 but still keep your office expenses at $20,000, your fixed expenses will now be only 6.67% of sales - a more efficient achievement that will be reflected in your bottom line (your Net Profit figure).

Separating out the fixed expenses also allows you quickly to see if there have been any unusual increases. For example, postage costs may have jumped considerably. The comparative figures (this year's postage expenses versus last year's) give you an opportunity to investigate and remedy any costs getting out of hand.

Categorising expenses

Sometimes the dividing line between fixed expenses and variable expenses is not absolutely clear. For example, if the monthly power bill shoots up from $200 to $800 because you're running extra shifts to complete some furniture orders, should that increase be shown as a variable cost of sales? Similarly if the (reasonably steady) delivery truck expenses suddenly increases significantly because you're delivering more sold items, under which category should this go? These are judgement calls that you can decide with the help of your accountant.

Notes on the P&L Statement

The P&L Statement is accrual based

The P&L is accrual based, not cash based. That simply means it includes all your income and expenses for the period, whether payment has been made/received or not.

For example, if you’ve invoiced for goods sold but haven’t been paid for them yet, they’re still included on the P&L. This provides a more holistic picture of how your business is performing.

What the P&L Statement leaves out

The Profit and Loss statement doesn't include:

  • Any personal items.
  • Any capital items.
  • Any loans or repayment of the loan principal (the capital portion of the loan).

What the P&L statement also includes

  • The interest on a business loan, since this is an expense item.
  • Depreciation on capital items.

What does the P&L tell you?

The purpose of financial statements is to help you manage your business more effectively. Here is some of the key useful information your P&L gives you.

Gross profit margin

  • What is it?
    This ratio shows whether your average mark-up is sufficient to cover all expenses and show a profit.

  • How to calculate it:
    Divide your gross profit by your sales and multiply by 100 to get a percentage. Using the example above for 2016:
    Gross profit of $151,500 ÷ by sales of $190,000 = gross profit margin of 80%.

  • How to use it:
    Compare your gross profit margin with similar businesses in your industry. If it’s lower, you could be underpricing. If it’s higher, and business is slow, you could be overpricing.

Expenses to sales ratio

  • What is it?
    This tells you if your expenses are increasing out of proportion to any growth in business.

  • How to calculate it:
    Divide your expenses by your sales and multiply by 100 to get a percentage. Using the example above for 2016:
    Expenses of $87,705 ÷ by sales of $190,000 = 46%. In other words, you incurred $46 of expenses for every $100 of sales.

  • How to use it:
    The lower your expense to sales ratio, the higher your profit. If the ratio is increasing over time, it’s a warning sign that expenses may be getting out of control – and you should look for ways to cut fat out of your business. In our example, the ratio was 46% in 2016 and increased to 59% in 2017 – not a good sign.

Other ratios

There are a number of other ways you can analyse the information in your P&L. For example, you can look at the ratio of wages to sales to see whether wages are increasing or decreasing in proportion to any increase in sales. If wages are increasing faster than sales, you may need to take action to either increase your sales or reduce your wage bill.

You can also pick any particular expense that you wish to monitor, such as advertising to sales. This ratio would enable you to measure the effectiveness of your marketing.

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