In the fast-paced world of entrepreneurship, it's easy to be swept up in the whirlwind of innovation and growth.
The looming threat of ChatGPT coming for your industry, the constantly shifting market, and all kinds of conflicting and dissenting voices coming from all sides!
Regardless of where your business is at when it comes to innovation and growth, there is one essential aspect of successful businesses that is consistent across every industry and every size: financial health.
Understanding the basics of business finance and what goes into your financial health is important for every business owner. No matter the size, location, industry, or any other differentiating factor, every business must have a strong financial foundation to succeed.
Over every other financial metric or ratio, there is one key document that offers valuable insights into your business's financial performance. The Profit and Loss Statement (P&L).
In this article, we will explore what a P&L is, why it is useful, its structure, and how you should be leveraging the information in your P&L to build a business that will remain profitable and financially healthy into perpetuity.
What is a P&L, and why is it useful?
A P&L, also known as an income statement, is a financial document that summarizes your company's revenues, costs, and expenses during a specific period. This means that you'll see the exact financial data from a specific day, month, quarter, or year.
Understanding your P&L can help you understand your business's profitability; what's left over after you've made money and then spent it? There are several financial insights that come from a well-formatted P&L.
Specifically, reviewing an accurate, concise statement of Profit and Loss can enable the following:
- Monitor your business's profitability and financial health.
- Identify trends and areas of improvement.
- Make informed decisions for future growth and investment.
- Satisfy the requirements of lenders, investors, and other stakeholders.
How is a P&L Structured?
A statement of Profit and Loss is typically structured into three main sections: Income, Cost of Goods Sold (COGS), and General Expenses.
The income section of your P&L includes all the revenue your business generates during a specific period.
Income is the economic engine of a business. It's generated through the sales of products or services. The total revenue is calculated by adding up all these sources of income.
Cost of Goods Sold (COGS)
Cost of Goods Sold is the direct cost of producing the goods or services your business sells. Without these costs, you wouldn't be able to provide the product or service that your business sells. Therefore, you wouldn't have income.
These costs can include raw materials, labor, manufacturing overhead, and other expenses directly linked to the production process. For example, a company that sells candles needs to purchase wax, wicks, glass jars, and labels. They may also have a manufacturing line in which their candles are assembled. The costs associated with each unit that they create are a Cost of Goods Sold.
Subtracting COGS from your total revenue yields your Gross Profit.
Once we're able to calculate our gross profit, we can also calculate our business's Gross Margin. Gross Margin is an easy calculation that tells us the percentage of every sale that the business profits on. Gross Margin is calculated by dividing Gross Profit by Income.
For example, if we have a Gross Income from selling our products of $100,000, and our total COGS is $50,000, our Gross Profit is $50,000, or $100,000-$50,000. To calculate our Gross Margin, we simply take our Gross Profit of $50,000 and divide it by our Gross Income of $100,000 to get 50%.
This means that for every $1 in sales our business receives, we have $0.50 remaining.
General expenses are all the indirect costs of running your business that are not directly related to producing goods or services.
These general expenses often include salaries, rent, utilities, marketing, and other administrative expenses. At their core, these expenses are the ancillary items that allow your business to keep running!
Deducting general expenses from your Gross Profit results in your Net Profit, which reflects your business's overall profit (or loss) during the specified period.
How to Use Your P&L to Make Decisions
Your statement of Profit and Loss carries a lot of information in it that, when viewed properly, can help you make better decisions about guiding your business to success.
As a small business owner, you should regularly review your statement of Profit and Loss. It's important to look for trends in your business and identify ways to improve your spending and earning! A P&L carries the data that you need to understand the financial impact of things like hiring on additional employees, investing in a new marketing campaign, or taking on a new office lease.
We've found it most helpful to view your profit and loss by month in order to see the largest amount of data possible. Breaking down your P&L into monthly segments offers several advantages:
- Enhanced Visibility: Monthly data provides a clearer picture of your business's performance, making it easier to identify trends and fluctuations.
- Timely Decision-making: With up-to-date financial information, you can make informed decisions and quickly address any issues that may arise.
- Accurate Budgeting and Forecasting: Monthly P&Ls enable you to create accurate budgets and forecasts, helping you allocate resources more efficiently.
- Improved Accountability: Regularly reviewing your P&L ensures that you stay accountable for your business's financial performance and encourages proactive management.
A comprehensive understanding of your P&L is crucial for maintaining your business's financial health and success.
By learning to read and analyze this essential financial document, you can make well-informed decisions, identify areas for improvement, and steer your business toward sustainable growth.
Most business owners aren't equipped with the financial background necessary to create a robust financial foundation from which a useful Profit and Loss is generated. It takes an experienced, knowledgeable accountant to aggregate and communicate your business's financial information correctly.
For that reason, it's important to work with an accountant, bookkeeper, or financial coach to ensure that you're getting the most insights from your financial reporting possible.
Remember that the key to successful financial management lies in consistent monitoring and evaluation, so make it a habit to review your P&L regularly and always stay on top of your business's financial performance.