The accounting side of your business can be a little intimidating and maybe a little scary if you're unfamiliar with all of the terminology. While it isn't necessary to go back and earn a degree in accounting, it can be helpful to understand some basic terminology to better understand your businesses' profitability. Whether you’re a new business owner or have been in the game for a while, you’ve probably heard of a profit and loss statement or P&L for short. Its’ name is pretty self explanatory, but there are some moving parts...
So, What's a P&L Exactly?
A profit and loss statement is a basic financial statement that shows how much your business spent and earned over a specific time period. Your profit and loss statement shows your revenue minus expenses and losses. The final outcome is either a profit or a loss.
A P&L can also be referred to as an income statement so don't get confused between the two; they both mean the same thing. When preparing an income statement, small business owners have two reporting options: a single-step or a multi-step P&L statement.
A single-step profit and loss statement is fairly simple. It tallies your total revenue, then subtracts your total expenses to calculate your net income. A multi-step P&L, on the other hand, requires multiple calculations to arrive at your final net income. The type of your business would help determine which format is best. Let's break down the P&L and explain all of its' components.
Types of P&Ls: Cash vs. Accrual
Cash basis: The cash method, also known as the cash accounting method, is only used when cash goes in and out of the business. This is a simple approach that only accounts for money received or paid. When cash is received, a business records the transaction as revenue, and when cash is used to pay bills or liabilities, the transaction is recorded as a liability. This method is commonly used by small businesses and individuals who want to manage their personal finances.
Accrual basis: The accrual basis records revenue as it is earned. This means that an accrual method company accounts for money that it expects to receive in the future. For example, a company that delivers a product or service to a customer records the revenue on its profit and loss statement even if it hasn't yet received payment. Similarly, expenses are accounted for even if the expenses have not been paid yet.
How to Read a P&L
The revenue or top-line portion of the profit and loss statement shows your business's revenue for analysis. Revenue summarizes your sales and activity for the reporting period. If your business has multiple revenue sources, the P&L statement may separate and combine them to form an overall revenue picture. With this structure, you can evaluate your overall revenue as well as each revenue stream broken down.
Business expenses, such as salaries, benefits, rent, utilities, etc. are included in operating expenses. The cost of making your product or the cost of goods sold (COGS) are examples of direct costs. For example, if you own a bakery and sell different types of pastries, the ingredients used to make your products are direct costs. COGS is essentially the cost of an inventory item. This category does not apply to service-oriented businesses like a law firm for example since they aren't selling tangible products.
Determining Gross Profit
Some profit and loss statements include a line for gross margin, which is direct costs minus revenue. This calculation determines how much money your business has available for operating expenses. If your business is a service company without COGS, it won't have a direct cost line or gross margin. Instead, the profit and loss statement will most likely list operating expenses as well as revenue-generating expenses, such as the cost of a sale.
For businesses with COGS, operating income, also known as EBITDA (earnings before interest, taxes, depreciation, and amortization), is calculated by subtracting operating expenses from the gross margin. Operating expenses can be deducted from revenue with businesses without COGS.
Interest expenses are typically incurred when a business borrows money, such as through a business loan, line of credit, or credit card. On your P&L statement, interest expense is the total interest payment you make to creditors for a specific period.
You're probably tired of seeing the word tax everywhere but I'm afraid they're here to stay... This part of a P&L shows how much taxes you paid or expect to pay.
This is the "bottom line" that everyone talks about. It's also known as net income or net earnings. You began with your revenue as your "top line," then subtracted direct costs, operating expenses, and so on. What remains is your profit, or potentially your loss if you spent more than you earned... try not to do that.
So, Why is the P&L So Important?
The profit and loss statement is the best tool for measuring your business's success. It's a report outlining the company's "bottom line." Financial advisors can read through a profit and loss statement and understand the company's financial health as a whole. This information can be important to business partners, board members, or maybe shareholders. When read correctly, a P&L report can not only tell whether your business is successful, but it can also provide some insight on how the data relates to expectations and previous years.
While this side of your business may seem intimidating, it's important for you to understand where your business stands financially and to determine the best ways to increase profitability.
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