Keeping track of how much your business earns and spends each quarter is pretty easy when you first open your doors. You don’t need much more than a little notebook or a good memory when you’re only dealing with a few clients and a couple of suppliers, after all. Plus, chances are you don’t have the time or energy to prepare detailed financial statements following generally accepted accounting principles (GAAP) while trying to get your business off the ground.
As your business grows, however, you’ll quickly find that you need more than ad-hoc accounting. In addition to making it easier to monitor your business’s financial situation, good old-fashioned accounting practices and financial statements give you the kind of high-level view of your operations that you just can’t get when you’re in the weeds.
Every public company and most established private companies prepare three main types of financial statements each year: Balance sheets, cash flow statements, and profit and loss (P&L) statements. Balance sheets and cash flow statements are vital components of financial reporting, but today let’s focus on P&Ls, how to read them, and why they’re essential for small business owners.
What is a P&L, and What's it Used For?
Profit and loss statements, also known as income statements, are important financial documents that summarize the revenues, costs, and expenses a business incurs over a given period. P&Ls are so crucial that the Securities and Exchange Commission (SEC) requires every public company to produce and provide P&Ls as part of their quarterly and annual reporting. Small and private businesses don’t have those exact requirements, but many still take the time to prepare P&Ls and other financial statements on the same schedule.
Businesses of any size can benefit from preparing P&Ls every month. Applying for a loan or a line of credit is a lot easier with accurate financial statements, for instance, and potential investors are a lot more likely to consider proposals that include balance sheets, cash flow statements, and P&Ls. Having an up-to-date P&L comes in handy for calculating tax liability when filing season comes around, too.
P&Ls are good for more than just acquiring additional funding and keeping the IRS happy. They track the changes in a business's accounts over the period in question, which makes them indispensable for measuring performance and planning purposes. After all, it’s a lot easier to identify trends, spot potential problems, and opportunities, and make concrete plans based on hard numbers than it is to rely on your intuition.
Now that you know a bit about what P&Ls are and why they’re important, let’s talk about how to read them.
Profits, Losses, and Your Financial Story
P&Ls look a lot more complicated than they actually are. Sure, some of them have enough categories and line items to make your head spin, but every single one of those items is there for one reason: To calculate how much money a company made or lost during the previous period.
Most P&Ls are broken into a few categories, each with a varying number of line items that sum up at the bottom of the category. The primary categories are, in order of appearance:
- Operating Costs/Cost of Goods
- Operating Expenses
- Earnings Before Interest, Taxes, Depreciation, and Amortization
- Net Profit
You may be asking yourself: "What goes into each of these categories?" Here’s a quick breakdown:
This section appears at the top of P&L statements. It will include line items like:
- Sales: Revenues from selling goods and/or services
- Other Revenue: Includes revenue from all other sources
- Returns/Discounts/Allowances: Includes deductions from revenue from returned products, discounts, and other allowances
- Total Sales and Revenues: Calculated by adding up Sales and Other Revenue minus the total Returns/Discounts/Allowances
Cost of Goods Sold
This section reflects the amount of money a company spent to conduct business in the previous period. It includes items like:
- Materials: The amount spent on inputs needed to make a company’s products
- Overhead: Money spent on rent, depreciation, shipping costs, and any other costs needed for but not directly related to the production and sale of products
- Research and Development: Amount spent on research and development
- Total Cost of Goods Sold: Calculated by summing up Materials, Overhead, and R&D costs
After calculating all of your business's income and Cost of Goods Sold (COGS) expenses, Gross Profit is a handy calculation for understanding what's left over. Gross Profit is what you get when subtracting Total Cost of Goods Sold from Total Sales and Revenues.
This category reflects the expenses a company incurred over the previous period. Some of the categories may seem like they overlap with the Cost of Goods Sold category, but there’s a difference. Unlike Cost of Goods Sold, Operating Expenses include all costs of running the business that isn’t directly associated with producing products. It includes items like:
- Wages: The sum total of the wages paid to employees over the prior period.
- Advertising: The amount spent on marketing and advertising.
- Rent/Lease: However much a company spent on renting and/or leasing its offices, vehicles, etc.
- Utilities: The sum of all the utility bills from the prior period.
- Interest: Reflects the amount it cost to service a company’s debts in the period.
- Other Expenses: Includes all the company's miscellaneous expenses that don’t fit neatly into any other category.
- Total Operating Expenses: Like the other category totals, this one is calculated by adding up Wages, Advertising, Rent/Lease, Utilities, Interest, Other Expenses, and any other line item that fits in the expenses category.
Earnings Before Interest, Taxes, Depreciation and Amortization
Earnings Before Interest, Taxes, Depreciation and Amortization (heartily referred to as EBITDA by accountants) is a measure of profit before additional expenses like interest and depreciation are calculated. It's measured by subtracting all Operating Expenses from the Gross Profit number.
Profit (or Loss) Before Taxes
Some P&Ls have a line item that calculates profit before taxes are considered. This is an easy formula: add any Other Income that doesn’t fit the Revenue category to the Operating Profit to get the Profit (Loss) Before Taxes.
Net Profit (or Loss)
Now all that's left over is our Tax Liability: the amount the company paid in taxes the prior period. This number is subtracted from Profit (or Loss) Before Taxes to get the company’s Net Profit (or Loss).
See? It’s not as hard as it looks.
Profit and loss statements are crucial components of any company’s financial story. Not only are they essential for finding funding and applying for loans, but they also make it much easier for business owners and stakeholders to track their firms’ performance and identify potential strengths and weaknesses. Reading a P&L seems a bit daunting, like many financial statements, but they’re pretty simple. Just remember that profit and loss statements are precisely what they sound like. So add up the profits, subtract the losses, and keep a calculator handy just in case.