Understanding your Financial Statements Part 2 – Profit & Loss Statement
Your Profit and Loss Statement (P&L) tells you how your business performed over a certain period. It tells you how much:
- revenue you generated
- expense you incurred to generate that revenue
- profit remained for the business owner(s)
The Profit and Loss Statement in summary is:
Revenue – Expenses = Profit
Revenue is money made by your business. Your business will primarily make revenue from selling products or services and this will generally be shown as “sales” on your P&L, or “fees” in the case of a professional services business. Other revenue may come from interest or dividends on funds invested or gains on sales of business assets etc.
Expenses are financial outflows from your business, incurred to generate revenue or to run the business. Expenses may be:
- direct expenses, directly incurred to generate revenue, such as the cost of buying products for resale, or
- indirect expenses, incurred to manage your business, such as office rent, administration staff salaries and telecommunications.
Profit is the amount left over for the business owner. Profit can also be broken down into various types of profit. The most common classifications are:
gross profit, the profit after deducting direct costs from sales, and
net profit, the final profit after deducting all expenses.
Period covered by your P&L
A profit and loss statement shows the financial performance of your business over a specified period. Businesses typically prepare a P&L as part of their management accounts for a month, quarter or year-to-date. These articles are discussing financial statements which usually cover a financial year.
What to look for in your P&L
A P&L typically consists of a whole list of numbers and, without any direction as to what to focus on, can become confusing. To get valuable information on your business performance, you need to focus. Here we will discuss three numbers and how to find meaning with them:
- Gross Profit
- Net Profit
Sales (or fees) is the amount of revenue generated from core business activities. If you are a business coach with 20 clients, each paying you $250 per month, your sales should be $60,000 per year (20 clients x $250 x 12 months = $60,000).
For any number in your financial statements to be meaningful, it must be compared to something. $60,000 may provide a very healthy income for a semi-retired business coach, but would likely be a disaster for a full-time two-person partnership. Whether your sales figure is good or not depends on the needs of your business.
2. Gross Profit
Sales – direct costs = gross profit
Gross profit is only relevant if you have expenses that are directly incurred to generate sales.
Examples for a product business are the cost of goods for resale. For a furniture shop to sell a chair, it must purchase the chair. Each sale requires a purchase so cost of sales increase or decrease as sales increase or decrease.
Gross profit is relevant for a service business if it directly incurs costs, such as direct labour, to provide services. If you use a subcontractor to deliver a service to your client, paying them for each service delivered, their cost is directly incurred in providing services and will increase or decrease with sales.
If making an extra sale does not increase your costs at all, then you have no direct costs and don’t need to worry about gross profit. An example might be a business selling electronic products from its own website where an extra sale incurs no sales costs or production costs.
3. Net Profit
Total revenue – total expenses = net profit
This is where the expression “the bottom line” comes from. Ultimately, net profit, which is the number on the bottom line on the P&L, is the business owner’s return on their investment.
Although net profit is the most important figure, focusing on sales and gross profit can have a greater impact on improving results, as discussed in a later article.
These three measures, sales, gross profit and net profit, take into account all the activity in the P&L. Gross profit incorporates sales and direct costs while net profit incorporates all other revenue and expenses. When these measures are not what they should be, we can then drill down into the individual expense items to determine where improvements can be made.
In the next article, we look at the other primary financial statement: the balance sheet.