In this guide we aim to provide:
- The benefits of maintaining profit and loss statements
- A breakdown of a basic P&L structure
- Things to take into account, or caveats
- Special applications for your P&L records
Benefits of profit and loss statements
Profit and loss statements are very common financial documents used by successful businesses. In short, a P&L statement provides a high-level overview of your company finances. You’ve heard of ‘the bottom line’ - a financial term which has also become a byword for the thing that matters most. Well, your P&L statement is how you’ll come to know precisely what that bottom line is.
If regularly maintained, it can provide a valuable snapshot of business performance at any specific point. It can show the consequences of past financial decisions, and the effect of operations on your finances over time.
The bottom line of your P&L statement should answer, at a glance, any questions prospective investors or partners will have about the profitability of your business. It can also provide your company with insights to guide future decisions.
For many, it is an indispensable tool for identifying tax liabilities. Viewed in comparison, period by period, it can indicate patterns such as busy or costly months requiring resource reallocation. Armed with this information, you can ensure the business is capable of covering its outgoings.
For the above reasons, the maintenance of profit and loss statements is often required either by law or by the rules of society memberships. It is, without question, a prerequisite for seeking financial support from a bank.
Breakdown of profit and loss statements
The structure of a P&L statement is quite straightforward. You start with the top line (turnover or revenue). Then, through a process of subtraction, you end up with the bottom line – an accurate reflection of your net profit. The sections divide as follows:
Also known as the top line. A record of the total brought in via sales of products or services during the period covered by your P&L statement. It may include payments made to your business from sales of old equipment, property, or tax rebates. Non-profit organisations would include fundraising under the remit of turnover.
Also referred to as ‘cost of goods sold’ or COGS. Deduct the costs of each sale or service delivery from the ‘Turnover’ top line. Retailers of products, for instance, would deduct from the total turnover the cost of buying those products via the manufacturer.
By subtracting your direct costs from your turnover, as above, you find your gross margin. This is also known as gross profit. This will tell you how much you have left over to carry out other expenses.
Also known as operational expenditures or OPEX. Put simply, it’s a record of expenses incurred by your business which aren’t direct costs. These include rent, salaries, utilities, hardware, consultant fees, etc.
By subtracting your Operational Expenses from Gross Margin you reach the figure of Operating Income. This is also known as EBIDTA, standing for ‘earnings before interest, taxes, depreciation and amortization’.
Line by line, the rows following Operating Income subtract further liabilities, outgoings and expenses from your total turnover. The figures you would be expected to account for can be seen here:
- Interest - any due interest payments on loans, to be deducted from your total.
- Depreciation and Amortization - any assets owned by your company which lose value over time. Items such as vehicles and machinery decline in value and should be recorded before tax time.
- Taxes - You should also make a record of any taxes you pay, or expect to pay, on the sales you’ve made.
The fabled bottom line, also referred to sometimes as ‘net earnings’ or ‘net income’. After subtracting all the relevant figures above from your revenue, the figure you arrive at will indicate how you are performing. If you’re in the negative, you’re losing money.
The caveats of profit and loss statements
While we’re eager to emphasise the importance of P&L statements, it’s also vital to be aware of their limitations. It will not present the whole picture of your business. Its accuracy will also depend largely on the nature and practices of your organisation.
For example, profit logged on a P&L statement does not always equal money in the bank for every company. Your figure may include those for outstanding payments owed. Likewise, a P&L statement only logs the costs associated with completed sales, not the total front cost of your stocked goods. The same goes for items such as rent and bills. Unless you’ve seen to these tasks, there’s a chance the outgoings in your statement have not yet been paid.
There are other types of spending that P&L statements do not reflect. These include upfront costs of buying assets, principal debt repayments and dividend payments, for example.
The key is to use your statement in combination with other financial tools such as balance sheets, while taking your business’ obligations into account.
Using profit and loss statements
With the figures in your profit and loss statement, you are well prepared to understand and prove the durability of your business. There are several readings you can take away from glancing at your figures.
If you notice a decline in profits while sales increase, there’s a definite disconnect - a review of your costs or rate of growth is required. Are sales stagnating? This could be a sign of the need for marketing and growth opportunities. Keeping an eye on your expenses can give you advanced warning of rising overheads, giving you the time to swap office location or equipment provider.
Below you’ll also find some useful formulas to use in combination with your statement:
EBIT (Earnings Before Interest & Tax) = turnover – (COGS + OPEX)
This figure will show what you’ve sold while factoring in the cost of your inventory. In essence, it indicates the running cost of your business and is a great measure of performance.
Gross profit margin % = (gross margin ÷ turnover) x 100
The higher the number the better. If the figure is shrinking, there’s a chance your costs of production are on the rise.
Break-even point = fixed regular expenses ÷ gross margin
Use this formula to calculate how much money is needed to cover expected costs and still break even.
Net profit margin % = (net profit ÷ turnover) x 100
Your net profit margin as a percentage provides an insight into performance. If your percentage is declining in the long run, you may need to look at reviewing all costs individually.
Maintaining regular profit and loss statements provides a vital measure of your business performance. Their usefulness is without question in any sized financial operation. As demonstrated, the data you record will allow for quick calculations and insights. With these you will be better equipped to make and justify business decisions, to yourself as well as any stakeholders and financial backers.
Don't forget that all Workspace customers can get free advice on their business finance possibilities, with one-to-one consultations available from partners, Informed Funding, who may be able to suggest alternative funding options that you hadn't previously considered or been aware of.