Many entrepreneurs who never even look at their profit and loss statements (known as P&Ls) because they find them to be too complicated. This can be a big mistake.
The vast majority of entrepreneurs have chosen their paths because they are truly passionate about the work they do. But they typically do not have a whole lot of experience (or interest) in interpreting and analyzing financial data and reports.
Business owners do not necessarily need to have the same level of skill and training as a financial advisor to gain a good understanding of their company’s finances. However, it is important to know what a P&L is and the valuable information it provides you.
How are P&Ls determined?
All P&Ls are based on the simple idea that sales minus costs equals the profit you are making. It’s as simple as that. You can look at your sales or costs in more detail and add various subtotals, which is likely the source of confusion for many entrepreneurs when looking at their P&Ls—they’re seeing the trees, but not the forest.
P&Ls usually list sales at the top of the sheet, with costs below that and total profit at the bottom. The subtotals are still broken down with the sales minus costs formula, but are more focused figures that provide context to your total profits.
Additional confusion can come if different words are used for sales, costs or profits. In some circumstances, sales are called “revenue” or “income,” while costs are referred to as “expenses.” Profit may be referred to as “net income.” None of these alternate names change the meaning of the numbers on your statement.
Analyzing the components of your P&L
Costs and sales are often broken down into different categories. A business that sells its products both online and in a retail store might choose to separate income earned online and through its store on a P&L statement. The same goes for costs—just like you would separate expenses in your budget, your P&L can contain those same components.
A common way business owners divide costs is to separate costs not directly associated with delivering a product or service and those that are. For example, costs associated with workers’ wages and costs of producing the products are costs associated with delivering that product. This is known as Cost of Goods Sold (COGS).
Your COGS figure is an important part of determining your gross margin (also known as gross profit). To reach this number, subtract your COGS from your total sales. The resulting figure represents the money your company earns after accounting for the cost of delivering its products or services, without factoring in other expenses.
Take the steps you need to learn more about the basics of small business accounting so you can make more sense out of your P&L statements and engage in better financial planning. Work with an experienced financial advisor for further guidance.