How to read your Profit and Loss
For a small business owner there is nothing more important than having a solid grasp of your financial position. That is why accountants have devised three really nifty documents that pull together the entire financial picture of a company: the balance sheet, the statement of cash flows, and the profit and loss statement. These three documents give a business owner three different views of the business, and together provide a solid overview of how the company is doing financially.
Sadly, lots of business owners have difficulty reading these documents, and therefore have trouble gleaning insights from them. So, over the next few blog posts we're going to go over key points of each of them to give you a primer on why these are important.
Let's start with the Profit and Loss Statement:
When I teach my financial literacy classes, I like to start by explaining that the Profit and Loss (or, P&L as it's often referred to) is probably the closest thing to what most Americans would think of as a "budget." It isn't a budget--since it looks at past financial events--but it is laid out in a very similar way. Essentially, a P&L takes your business income, subtracts your costs and expenses, and shows what you have left.
The above image is of a sample P&L for ABC Business, Inc. While it's extremely simplified, it does a great job of highlighting the key pieces that make up a Profit and Loss statement.
Sales Revenue This is your top line revenue, meaning the full amount that you took in from sales of your product or service. This is usually the number most business owners are familiar with, but it is literally just the starting point for determining a company's profitability.
Cost of Goods Sold (COGS) The next number is the total "cost of doing business." This doesn't include costs of salespeople, or marketing, but the actually input costs for the product or service you produce. For instance, if you sell wooden toys, then the COGS will be the cost of the wood, screws, and direct labor required to produce the finished product. If you sell a service, then the COGS will usually be lower, but could still include the cost of labor that is directly responsible for delivering the service.
The key for considering labor in COGS is whether the labor can be reasonably attributed to individual products. For instance, if you own a mechanic shop then you can't deliver your service without mechanics, so the cost of that labor would go into your COGS.
Gross Profit Your Gross Profit is the amount you have left after COGS is subtracted from your revenue. So, if you sell a $200 watch, and it costs $60 to make, your Gross Profit is $140, or 70% Gross Margin(140/200). This number is very important because it tells you essentially how much money you have left to operate the business.
Expenses The next part of the P&L are the expenses, listed above as "Selling, general, and administrative expenses." This is where you put all the other "costs of doing business," all the staplers, paper products, salaries, benefits and lawyer costs. Everything you need to operate your business goes here, and usually this makes up the bulk of the costs of operating your business.
Operating Earnings (EBITDA)
Once you've subtracted all the costs from your revenue, you're left with what is called EBITDA (earnings before interest, taxes, depreciation, and amortization). Essentially, it's the money you have left over before all the financial variables come into play. This is a very important number because it gives you a solid idea of how financially healthy your company is. While fiscal concerns like taxes and interest might reduce this amount more, usually your Operating Earnings will be close to your Net Profit, and also give you an idea of how profitable the base business operations are. That's why most investors evaluate businesses based on their EBITDA.
Interest and Taxes These two numbers are going to fluctuate based on the amount of profit and whether you've borrowed money or not, but after you've figured out the operational profit, you subtract first any interest you've paid on loans, and then the amount in taxes owed on business profits.
Net Profit After everything is said and done, the "bottom line" is your Net Profit. This is how much money you made after everything else was paid. Ideally this number should be a positive one, but there are certain situations (which your financial consultant could explain) where running at a loss might be advantageous for tax purposes.
So, there you have it. These are all the parts of a P&L. Next, we'll be breaking down what makes a Statement of Cash Flows so important.
Schedule sometime to chat about having a financial literacy class at your business today!