Profit serves as the primary incentive behind most business operations. So, it is a given for business owners to get a complete overview of it. The best way to evaluate your profitability is by creating a profit and loss statement.
It summarizes your business’ revenue and expenditure within a specific period. These are usually prepared quarterly or annually and serve as an honest standing of your business' finances. Assessing a profit and loss statement allows business owners to find areas to work on.
While all this sounds desirable, you must be wondering how it can be prepared. For starters, you can read through this guide. Here, we have detailed all the information an SME owner should possess about these statements.
A profit and loss statement proposes a summary of the business’ expenses, revenues, and profit/loss within a specific period.
By studying the statement, you can assess your sales generation, expense management, and profit creation abilities. The statement uses accounting principles based on accrued expenses, matching, and revenue recognition. That is why businesses perceive it differently from a cash flow statement.
Why do businesses prepare profit and loss statements? Generally, the idea behind these statements is to attract investors and banks by showcasing your profitability.
Additionally, every business has other essential financial statements too:
- The balance sheet (summarizing the assets and liabilities portfolio)
- The cash flow statement (representing the business’ cash transactions)
- The profit and loss statement (highlighting the business’ profitability)
This statement has multiple names like the statement of operations and income statement. The difference in the name accompanies a slight difference in the intent behind their distribution too. Income statements are prepared to share with outsiders like banks and the government. On the other hand, a profit and loss statement is used within the business’ confines, marking the sole difference between the two.
Here is an imaginary profit and loss statement for a better understanding:
A profit and loss statement is read from top to bottom. This statement will help you understand every factor involved in your business' finances.
A profit and loss statement starts by listing the total revenue earned by the business. Depending on your accounting basis (accrual vs. cash), the method of calculating the revenue will differ. However, the figure still depicts your sales revenue.
As the name suggests, COGS is the cost incurred while producing goods within a specific period. It comprises direct expenses like labor, shipping, and raw materials. Indirect expenses like bank fees, rent, and utilities are listed in a different section.
The next step on the list is gross profit, calculated after deducting COGS from sales total revenue. Gross profit shows a business’ profitability after direct expenses but before overhead costs. The number provides a rough sketch of your market performance.
The business in question has accumulated expenses into SG&A (Selling, General, and Administrative Expenses.) Some businesses try to separate their expenses into the operating and non-operating sections. This may provide better business insights but depends entirely on your preference.
After deducting SG&A expenses from the gross profit, businesses are left with profit before interest. The name is self-explanatory as it indicates the profit before the interest is deducted.
Most businesses have loans or credit, which incur monthly interest. The interest is deducted from the profit and gives us the profit before tax.
The section provides your profit before the taxes have been filed.
Depending on your business and its earnings, the amount of tax is calculated. This is the final expense on the profit and loss statement.
Once you have made every adjustment, you find your true profit. The net profit highlights your total profit from a specific period and can be used to compare your business performance.
Chances are, your accountant already possesses a profit and loss statement template. You can even find stock statement templates on the web or generate a custom one through certain software. Here is a ready-made profit and loss template and bank reconciliation template for your reference.
There can be multiple types of profit and loss statements depending on the structure. The above-stated example uses a multi-step profit and loss statement. While the format suits most modern businesses, many SMEs try to keep it simple.
In such cases, they opt for a single-step profit and loss statement. Its structure is straightforward; you simply add the net revenue and deduct the net expenses, providing the net profit.
Here is an example of a single-step profit and loss statement:
The approach provides a quick preview of your business’ net profitability. While it is simple, it is not used nearly as much as a multi-step profit and loss statement. It can be used in crunch times but is not recommended for long-term use.
Some businesses prefer adding an extra section with the revenue percentage, giving a better indication of the profit and loss statement. This type of statement is called a common-size profit and loss statement. Here is an example to get a better idea.
Simply add the respective figures in the format, and you are good to go. This approach allows business owners to set comparisons between their past performance and the competition. Seeing the percentage change provides a quick understanding of the matter compared to mere numbers.
'Balance sheet vs. profit and loss statement' is a commonly searched topic on the web. You can assess a business’ operations and profitability through both of them, but they are vastly different.
A balance sheet highlights a business’ assets and liabilities. It shows your business’ status at any given moment.
On the contrary, a profit and loss statement showcases a business’s profitability. It shows the cash flow over a specific period.
Accounting presents multiple tools to assess a business’ profitability, but the profit and loss statement is the best alternative. It puts into perspective how the business performed over a specific period. That is why every modern business prepares the statement quarterly/yearly.
The blog has specified critical information regarding the profit and loss statement and how it is prepared. However, if you find this too burdensome, you can outsource all your bookkeeping needs to industry leaders like Fincent too!