Want to learn how to read a profit and loss statement? You are in the right place!
Financial statements provide a means to check the financial health of your organization, giving you a greater understanding of where capital is being spent, how well product lines are performing, and what your overhead expenses truly are. But for you to get the most out of these statements, it is essential that you know how to read and analyze the information they contain. While our focus today is how to read a Profit and Loss Statement (P&L), the goal is to give you tips to help you better understand all aspects of your financial statements. Let’s start by learning what a P&L is and then how to analyze a profit and loss statement effectively.
What is a Profit and Loss Statement?
A profit and loss statement, sometimes referred to as an income statement, is a financial report containing a company’s costs, profits, and revenue. It assists lenders and investors in determining a company’s profitability, but the P&L also demonstrates the ability of your business to increase sales and profits by controlling your debts and expenses.
Who Prepares the P&L Report?
Your bookkeeper or accountant will prepare your P&L statement, which can be done as a part of your monthly financial reports. It can also be compiled quarterly or annually.
What You Can Learn from a Profit and Loss Statement?
Your P&L statement can show your sales and expenses for a specific period of time. When analyzing these statements, you can compare from one month or quarter to another to determine trends and give you an idea of potential problem areas within your finances.
Financial Health of a Business
It is important to compare income statements to identify changes in revenues, operating costs, and net earnings over time. For instance, your company’s revenues might be growing steadily, but your expenses might be growing at a much faster rate than your revenue. The goal is to get familiar with the finances of your business, using tools of analysis to determine the overall financial health of your company. Simply put, the P&L statement lets you know what your bottom line is. If your P&L is positive, then it means you are making money, but if your gross profit is low or in the negative, then you may need to reassess your business model. Here are some of the things you can learn from your P&L statement.
Business Trends Over Time
When you compare P&L statements, you can identify trends in sales and expenses. Those trends can assist you in making adjustments to focus on the areas of your business that are growing and to reduce lines of products that are not doing well. You can identify important fluctuations that inform your business decisions. If you cater, for instance, and notice that you have a strong second quarter consistently, then you can expand your marketing to capture a greater share of the business during that quarter.
Operational Changes or Improvements Needed
On the expenses side, you can see trends that help you determine whether your overhead costs are in line with your industry or if adjustments are needed. For some business owners, this type of analysis is key to figuring out where operational changes or adjustments might be needed in how you run your company. This could involve changes to processes to reduce costs through increased efficiency.
Alternatively, you may also discover areas where you can afford to invest more and expand your business model to capture a larger share of the market and grow your reputation within your industry.
What to Do Once You Have Your First Profit and Loss Statement
When you have your first profit and loss statement, you might first look at your bottom line, which is the net profit after all expenses and COGS have been subtracted from your revenue. But there is so much more that you can learn from your P&L statement.
With the information you have from your P&L statement, you can make important immediate decisions, like whether you can afford to hire more staff or expand into a larger retail space. It also helps you to have the information to make strategic decisions for the future, from planning your tax strategy to maximizing your business model for future growth.
The Components of a Profit and Loss Statement
Your P&L statement is made of several components, each a reflection of an aspect of your company’s financials. With that in mind, let’s talk about what each of those components are and how they can be a part of your analysis of a profit and loss statement.
It depicts the detailed income from numerous sources to assist in evaluating your company’s revenue sources, including the products contributing to sales. This revenue doesn’t include income from other sources that are not directly related to sales.
Cost of goods sold (COGS)
This refers to the costs associated with production of your products or services, such as the costs associated with manufacturing your water bottles or dishware. Keep in mind that the COGS is not going to include all your operational expenses, just the ones directly related to the creation and selling of your product line.
Your company’s gross profit is what you make after subtracting the COGS from your revenue, but it does not include indirect income and expenses.
Expenditures are payments of cash or credit for goods and services, either to obtain new assets, improve or repair assets, or reduce liability. An expenditure is recorded at the time of purchase, compared to an expense, which is accrued over time.
Recording expenditures can help to limit operating costs to the lowest possible amount. Keep in mind that an expenditure is the total purchase price of a piece of equipment or other goods and services.
Operating earnings isolate profits realized from your company’s core operations. It refers to the amount of profit realized after you subtract expenses directly associated with running your company, including COGS and general or administration expenses, selling and marketing, research and development, depreciation, and other operating costs. Operating earnings exclude non-operating expenses, such as interest rates and taxes, so you can assess how well your chief lines of products and services are doing.
An interest expense is a cost incurred by your company for borrowed funds. It represents interest payments on any borrowings, be it bonds, loans, convertible debt, or lines of credit. To calculate an interest expense, you take the interest rate times the outstanding principal amount of the debt.
Earnings before income tax
Income before taxes is your company’s net income after all expenses, except your taxes, have been paid. This is a useful metric for comparing business performance because it removes the variable of taxes, which can change over time.
Income tax expense
Your income tax expense is the total amount paid in taxes, which can be broken down by federal, state, local, and sales tax. You need to be familiar with the tax laws that apply to your business, knowing that corporate tax rates can vary.
Your net profit is the bottom line and a true indicator of your company’s profitability. It is how much money your company makes after all expenses have been paid, including taxes and debt payments.
Your company, if it makes enough to cover all its expenses, is profitable. However, if your company is in the negative and doesn’t have enough income to cover all related expenses, then you are operating at a loss. This means you need to make significant changes to your business model or even consider closing your business if this continues year after year.
How To Read a Profit and Loss Statement
1. Define the revenue
To determine your company’s revenue, you need to know what it entails. Revenue is generally the value of all sales of goods and services recognized by a company during a specific period. It also makes up the top line of your P&L statement. Expenses will then be deducted from this number to provide profit or net income.
Your revenue formula can be simple or complicated, depending upon the business. Product sales, for example, are calculated by taking the average price at which your goods are sold and then multiplying it by the total number of goods sold. Service companies calculate the value of all their service contracts or the number of customers multiplied by the average price of your services. These formulas can be expanded for more detail, including revenue forecasts all the way down to individual product or customer levels.
2. Understand the expenses
Operating expenses are the selling, general, and administrative expenses that don’t relate to the production of any product. Note that operating expenses can greatly impact the profitability of your business over time. If you want to improve your company’s bottom line, reducing operating expenses may be your best option without impacting the price or quality of your current line of products and services. Once you have your operating expenses, then you want to subtract them from your revenue as well. Other expenses include your COGS and your non-operating expenses, all of which will end up being subtracted from your revenue and income.
3. Calculate the gross margin
Gross profit is what your company makes after deducting the costs associated with making and selling your products or the costs associated with providing your services.
The formula for gross profit is:
Net sales – COGS = Gross Profit
Net sales are equivalent to revenue or the total amount of cash generated for a specific period and can include discounts and deductions for returned merchandise.
4. Calculate the operating income
When you calculate operating profit, you eliminate several indirect factors that can end up obscuring the true performance of your company. Additionally, as you complete these calculations, you can find your operating profit margin, which will show you how well your company is doing at turning gross revenue into profit. The formula for operating profit/loss is:
Operating profit/loss = Gross Profit – Operating expenses – Depreciation – Amortization
This operating profit calculation is also referred to as earnings before interest and tax (EBIT). You can opt to present your operating profit in place of net income on your P&L statement.
5. Use budget vs. actual for insight
When you compare your expenses and revenue from your P&L against your budget, you can see whether your budget is on target or if your expenses are larger than you anticipated.
6. Check the year-over-year (YoY)
It compares a company’s moments in time since seasonality and other factors can cause your fiscal quarters to fluctuate. Comparing how the company performed at the same time of year to previous years is one way to determine whether the quarterly earnings are in line with prior years or if there has been a major deviation. If you see a major deviation, then you will want to do an analysis to determine what might be the cause.
7. Determine net profit
Your P&L statement should have your net profit/loss, which is the amount of funds left after all expenses have been paid. If your business does not make enough to cover all your expenses, then you will be operating at a loss. Note that there are several places where you can begin to notice if there are issues that make your business unprofitable, but if changes are made, then you could turn your company profitable.
What Is the Importance of Reading a P&L Statement Accurately?
When knowing how to read a profit and loss statement accurately, you can analyze your company’s performance, making it easier to determine where changes might need to be made. However, if you don’t read it accurately, then you could miss critical information that can assist you in determining how you want to grow your business.
Frequently Asked Questions
- What is the difference between operating income and net income? Operating income is revenue less operating expenses. Net income shows the profit remaining after all costs incurred in the period have been subtracted from the revenue generated from sales.
- How do non-operating income or expenses impact the bottom line? Non-operating income and expenses can affect the bottom line of your P&L either positively or negatively based upon the amount of the income or expense.
- How can I compare my current period profit and loss statement to previous periods? In your accounting software, you can run a comparison report that can help you to see how to analyze a profit and loss statement because you can see the changes over time.
- Are there any red flags or warning signs to look for in a profit and loss statement? There are three major red flags to watch for as you read your P&L statement. These include the following: Declining profit and shrinking profit margins; wage costs increasing faster than revenue; and decreased sales and marketing spending.
- How can I use the information from a profit and loss statement to make informed business decisions? It can assist you in identifying seasonal, monthly, quarterly, and annual trends, as well as spot opportunities for growth. You can also prepare for potential shortfalls, identify theft, evaluate your business strategy, and identify profitable products or services.
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Knowing how to read a profit and loss statement is key to knowing whether your business is profitable or not. As you learn how to analyze your profit and loss statement, you can identify places where you can reduce costs, increase sales, and balance your cash flow more effectively. With opportunities for growing your business everywhere, knowing your financial health is key to finding the right opportunities for your company.