Owning a company requires adopting financial responsibility to strategize ways to make a profit, even when business isn’t going well. The easiest way to do this is by building P&L statements.
There are three main financial statements every small business owner should use: P&L statements, cash flow statements, and the balance sheet. P&L statements, or profit and loss statements, show where revenue is earned and money is spent.
P&L statements help small business owners understand how the business is doing in a specific time period. P&L statements are also important for business milestones, such as a physical review of the company when inquiring with an investor.
If you want to understand when profits are lost and gained, read on and find out everything about these statements.
P&L Statements Have Many Names
There are different ways to identify P&L statements. They’re commonly referred to as:
- Statement of Profit and Loss
- Income Statement
- Statement of Operations
- Statement of Financial Results
- Income and Expense Statement
Most professionals, entrepreneurs, and investors call the P&L statement an “income statement.”
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How to Read a P&L Statement
If you’re not used to reading financial statements, the P&L statement can be a bit overwhelming at first glance. Unlike the balance sheet, a P&L statement shows income and expenses over a specified period of time — usually monthly, quarterly, or annually.
Profit and loss statements can be broken down into three main sections: revenue, cost of sales, and operating expenses. Let’s use the example of a consulting agency, to break down the sections of a P&L statement, as well as the key metrics to pay attention to.
Breaking Down the Sections of a P&L Statement
The revenue section shows money brought into the business over a specified period of time. This section is often referred to as the “top line.” For businesses that use the accrual method of accounting, the revenue section will include all recognized revenue for a given time period — including invoices that have been sent even if the cash hasn’t yet been collected.
Cost of Sales
The cost of sales (COS) section shows money spent on delivering products or services. Another way to think about COS is direct cost inputs into generating revenue. Sometimes, cost of sales is referred to as cost of goods sold (COGS), depending on the business type. These terms are typically used interchangeably in accounting, though there are a few exceptions.
Cost of sales is variable, meaning it changes in relation to revenue. If cost of sales increases, revenue should (in most cases) increase, too. Similarly, if revenue increases you can expect to see an increase in the cost of sales section of your P&L statement. Cost of sales is important for calculating gross profit.
Not sure if an expense should be considered a cost of sales? Ask yourself, “If I stopped paying this expense, would I still generate revenue?” If the answer is no, the expense is likely a cost of sales.
Operating expenses account for money spent running the business day-to-day. Essentially, everything that isn’t revenue or cost of sales. Operating expenses are typically expenses such as rent, office supplies, or insurance and are important for the business to function properly.
Let’s check in on our consulting agency. They rent an office that’s equipped with telephones, internet, and basic office supplies. They pay their employees well for their great work and employ a few contactors. All of these items allow the business to function and support generating revenue, therefore they belong in the operating expenses category.
Other Income and Expenses
Revenue, cost of sales, and operating expenses are the three main sections of an income statement. Sometimes, there are other expenses that don’t quite fall into the operating expenses bucket, such as taxes. These items typically aren’t recurring transactions but are, in fact, costs of doing business. These other expenses may show up on an income statement depending on the time period in review. When they do, they’re accounted for under “Other Income and Expenses.”
Metrics on a P&L Statement
Gross profit refers to how much money is on hand to run the business. Gross profit is the first health test for your business that you can find on the income statement. To calculate gross profit, subtract the total cost of sales (or cost of goods sold) from the total revenue. Gross profit, sometimes called gross margin, should be a positive number indicating money available to cover operating expenses and still make a profit. Think of gross profit this way: once total revenue and the must-pay costs (cost of sales) are removed, how much money is left over?
Let’s check back in with our consulting agency. Looking at their monthly P&L statement, they brought in $191,114.87 in total revenue and spent $105,181.58 in cost of sales for the month, giving them a gross profit of $85,933.29.
Gross Profit = Total Revenue – Total Cost of Sales
Net income is the total incoming revenue minus the cost of goods sold and all other business expenses. Think of net income as the percentage of total revenue. Net income is commonly referred to as the “bottom line” because it lives in the bottom line of the P&L statement.
Net Income = Gross Profit – Operating Expenses – Other Incomes and Expenses
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Income Statements Show Profits Gained and Loss for a Period of Time
Income statements tell a story of the amount of revenue gained and lost in a specific time period. Small business owners can look at income statements monthly, quarterly, or yearly depending on their business size, health, and needs.
You’re not limited to creating one P&L statement per time period. Create as many as would fit your business needs. If you prefer to make yearly income statements and compare them to previous years, you can still make quarterly or monthly statements to view your profits gained versus profits lost.
That said, creating a P&L statement every month will give business owners timely information that they can use to run their businesses. Producing additional quarterly or annual statements can help to supplement those monthly reports and ensure the business is on track to meet long-term goals.
They Show More Than Profits and Losses
P&L statements can tell you much more than simply the amount of money you made and the amount of money you lost. Use your income statement to identify how much you’re spending and other necessary business expenses that cut down on profit.
The P&L statement also shows any changes made to your accounts, such as a new business checking or savings account.
You can also compare your income statements to your bank account and credit card systems to determine if you’re spending too much or if you’re in any credit card debt.
How to Use a P&L Statement
When you’re looking at the P&L statement, start with the top line to understand your revenue. Most business owners and managers have a sense of what they’re expecting to make in a given time period. Use your top line to measure against your goal for the given time period.
Next, head down to the bottom line to see if you were able to cover all expenses and make a profit. If there’s something you don’t expect, dig in. Have a net loss? Check out your gross profit first. Your gross profit could be positive and still equate to a net loss for a given time period. If that’s what your income statement shows, check to see if your gross profit was lower than the previous reporting period. If it is, that means you didn’t have quite enough to cover operating expenses for that time period. Dig into your operating expenses to see if you spent more, or if there are any uncommon fluctuations.
In other words, don’t discount it as a bad month and move on. Dig deeper.
Income Statements are Used to Make Important Financial Decisions
P&L statements are commonly used to review a company’s profits and are compared to past statements to determine if any decisions need to be made to cut down on costs or strategize ways to increase revenue.
When reviewing these statements, you may decide to cut down on staff. You could decide to buy materials from a different company or cut down on other expenses such as downgrading your office.
If you made a profit, you can find ways to increase your profit even further. You can also make other decisions such as hiring, upgrading equipment, and offering more benefits for your employees.
A successful P&L statement campaign combines the strategy of driving revenue while cutting costs.
Income Statements Help Investors
Many businesses find themselves looking for investors at some point in their growth. Since investors typically use their own money to help capitalize your business, they’ll want to make sure their investment is worth it.
When they evaluate the strength of your business, they will look at your P&L statements. Some may only look at your yearly statements, while others may request your quarterly or even monthly statements.
Income Statements Help Prepare Taxes
Businesses have to pay both quarterly and yearly taxes, and the amount they owe depends on their filing status and the amount of revenue they claim.
If you’re unsure of the amount of revenue you should claim, having an updated P&L statement will help when filing your taxes.
P&L statements also help your accountant or tax preparer. Be sure to submit your income statements to them, as well as the statements for the previous year.
These statements will help your accountant determine any write-offs or changes in your taxes that require a separate filing.
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Income Statements and Business Size
While P&L statements are important for any business owner, all businesses come in different shapes and sizes.
The CEO of a large corporation will look at a very different statement from a small business owner who sells artwork part-time.
The key factors of a P&L statement are documenting profits and losses in a certain amount of time. While all business owners should document all profits and losses, the amount of time to document them is flexible.
For example, the corporate CEO needs to document statements at least quarterly. He or she probably has several expenses such as a mortgage on an office and a lease on a warehouse and a large staff expanding multiple cities.
On the other hand, the part-time artist may only need to make their statements once a year. This will help determine how much sales they’re receiving alongside small expenses they need to pay.
Do I Really Need a P&L Statement?
The answer is simple: if you own a business, you need to make a P&L statement.
You may not think it’s necessary since a P&L statement isn’t usually required by the IRS, your business filing, or any other significant form. So it’s easy to overlook the necessity of this statement.
Medium-to-large size companies know how important a P&L statement is (and in some cases are required to create one) but it can be difficult for a small business or sole proprietor to understand why they should create a P&L statement. If you’re not generating a large revenue and have small business expenses, then what’s the point?
But what if you want to reach out to an investor or an accountant? Or you’re applying for a business loan? What if you just want to make smart decisions about how to grow your business?
This is why it’s important for all businesses, big or small, to get in the habit of creating P&L statements.
Even if your small business isn’t generating any sales, a P&L statement will show any expenses you’re making to sustain the business, and can even give you insight on marketing efforts to start gaining revenue.
Are You Ready to Start Creating Your P&L Statement?
Making an income statement may seem intimidating, but it’s easier now than ever. As long as you’re documenting all earnings and expenses, you can easily create—and read—your income statement.
At ScaleFactor, your bottom line is our top priority. If your company needs help with accounting, we can handle all your financial needs. Get in touch with us to find out how we can help.
And don’t forget to download our free cheat sheets to help you read and analyze all of your financial reports.
Post last updated on August 28, 2019.