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Unlike the Balance Sheet, which shows a snapshot of a business's health at a specific point in time, the Profit & Loss Statement shows the income and expense activity of a business over a particular period of time. A Profit & Loss Statement, often called an Income Statement, can be prepared for any given period of time: a day, week, month, quarter, year, or longer; often two or more periods of time are looked at in conjunction with each other to compare activity between each period. For example, you may look want to look at last month and this year-to-date, or this year-to-date and last year-to-date, or each month side-by-side for the entire year.
Typically, a Profit & Loss report is reviewed on a monthly basis. Why monthly? Because it is a long enough period of time to give you a solid picture of income and expense activity and trends, but short enough that you can spot potential issues and take timely action to address them if needed. It also coincides with the time frame used for the external reports for your business, such as bank statements, loan statements and credit card statements. This makes for easier reconciling between those supporting statements and your financial reports.
The Profit & Loss Statement consists of several parts:
Income/Revenue
The first part is the Income (also called Revenue) section. This shows the sales or income of the company during the period. You may have only one line for sales, or you may have multiple lines showing the different revenue streams for your company, as well as adjustments to income, such as customer discounts or returns.
Cost of Goods Sold/Direct Costs
The next part shows the direct costs of the business. This section is often called Cost of Goods Sold, or Cost of Services. Direct costs are those costs which are directly related to the products or services you sell. They can consist of labor, materials/goods, outsourced services, shipping/packaging expense and other costs. The key to determining whether a cost is a direct cost or not is to ask yourself if the cost would go up or down based on the volume of sales. If it varies, then it typically is a direct cost.
Gross Profit
When you subtract the Cost of Goods Sold from the Income section, you get the Gross Profit, which is the income the company is generating before subtracting all of the operating expenses. In addition to the Gross Profit, the Profit & Loss Statement will often show the Gross Profit percentage, which is the Gross Profit number divided by the total income. This percentage is a key piece of information for a couple of reasons: 1) It allows you to compare your company's profitability with any other company regardless of sales volume and 2) It helps you spot trends in your profitability (i.e. "my gross profit % was lower last month than in previous months - what happened?") When you are looking strictly at the gross profit dollars, it is much harder to compare from month to month or against your competitors' performance.
Operating Expenses/Overhead
The third part of the Profit & Loss Statement is the Operating Expense (also called Overhead) section. This shows all of the costs of the business not directly related to production. These costs are usually somewhat fixed and don't vary much based on the volume of production. Examples of overhead expenses are: owner and/or administrative staff salaries and benefits, business insurance, rent, office expenses, and advertising. The Overhead section of the Profit & Loss gives you a good idea of what it costs to run your business, regardless of your sales volume. So, if your overhead is running about $5,000 per month, you would need to make a gross profit of at least $60,000 per year just to break even.
Other Income & Expense
The last part, Other Income & Expense, includes income and expenses not directly related to the operations of the business. Items in this section typically are interest income, finance charge fees, and income or loss from the sale of assets. You need to also take into account the expenses in this section when determining your income goals - new business owners often overlook the cost of financing when projecting business profitability and can wind up short of expected goals.
There is a great deal of information contained in the Profit & Loss Statement - so be sure to get familiar with all of the numbers on your company's statement, not just that bottom-line number that is so tempting to jump to! By analyzing the various sections of your statement, you will become much more familiar with the trends in your business and will be able to make better decisions about the operations of your business.
If you would like a more in-depth lesson on reviewing and understanding your company's financial statements, please contact me at Tracey@FirstTierAccounting.com to schedule an appointment.
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