Is your business making money? Is it really? The only way to know, to really know, is to learn how to read a basic Profit & Loss Statement. You see, the numbers don’t lie.
Your Business Profit and Loss Statement (P&L) is both the most popular and common financial statement in any business reporting suite because it tells you, categorically and unambiguously (assuming your data entry is correct), if your business is actually profitable. A dance around the P&L is as essential a component of our Brunch with your Numbers process as a delicious brownie- it tells you where your bottom line is sitting. Actually, so does the brownie, but let’s stay on track.
The bare bones of a Basic P&L are:
Costs of Goods Sold
Of course, this can be managed in ye olde spreadsheet, but the real magic happens when the details are taken into an accounting software program, and all of the top bookkeepers do this.
Regardless of platform, spreadsheet or cloud-based software, a P&L starts with a summary of your Income, details your Direct Costs (or Costs of Goods) and your everyday Operating Expenses (OPEX), and then shows you the crucial “bottom line”—your Net Profit.
Want to know if you’re in the red or in the black?
Make sure your accounting data entry is up to date, then just flip to your P&L report and look at the bottom- is it a positive or negative number?
Unlike the cash flow statement which can be a bit more complicated, your P&L is fairly easy to read and understand. Here’s a quick run-down and explanation of what each section means and where the numbers come from.
The money that you’re bringing in from the sales of your products and services.
Obviously, your income is a pretty significant number as it’s what you need to cover your business expenses. The lower your income number, the lower your expenses need to be in order for your business to remain profitable.
Direct Costs or Cost Of Goods Sold (COGS)
Direct costs, also called cost of goods sold (COGS), are the costs that the business incurs when it makes its products or delivers its services. Don’t include things like rent or payroll here, however you would include the things that directly contribute to each sale, such as materials, packaging, freight and so on.
However, if you’re a service-based consulting business, it’s possible that you have very low or even no direct costs. You might have costs associated with printing reports and photocopying, but not many other costs.
Gross Profit/Gross Margin:
Gross Profit is one of the most critical signifiers of your business’ health- the higher the margin, the better, as it indicates your business is running more efficiently. This amount tells you how much money the business has left over to cover your daily/weekly/monthly expenses after it’s covered the cost of the product or service you are selling. Simply subtract your direct costs from your income and that provides you the Gross Profit (GP):
Income – Direct Costs = Gross Profit
For example, if you buy a widget for $1 and sell it for $3, your Gross Profit on that sale would be $2.
The metric Bookkeepers use for Gross Profit is the “Gross Profit Percentage”, which represents the GP number as a percentage—the higher the number, the better. You calculate that percentage by dividing your gross profit by revenue:
Gross Profit / Income = Gross Margin %
When you have a high Gross Profit %, it means that it costs you very little to deliver your product or service and you’ll have the majority of the money from every sale left over to cover your other Operating Expenses.
Operating Expenses (OPEX):
Operating Expenses cover all of the expenses that you incur to keep your doors open. This usually includes your rent and outgoings, subscriptions, computers, wages and other employment expenses, marketing expenses, research and development expenses and so on.
OPEX / Income = OPEX %
In this metric, we want that % to be lower, as this means that you are controlling your everyday expenses against the total income you are earning. A clear understanding of expenses will dictate the sales needed to cover your bases to breakeven, but more optimally, to make a profit.
Also known as net earnings, it’s the “bottom line” that you hear so much about.
You started with your Income as your “top line” and then subtracted Direct Costs and Operating Expenses. What’s leftover is your Net Profit, or potentially your Loss if you ended up spending more than you earned.
Now, we’ve just explained a Basic Profit & Loss, there are other data points that can be included in a P&L, such as Depreciation, Interest and Taxes Payable, but that’s a story (or a post, to be more accurate) for another day. The most important takeaway from this post, however, is that profits are NOT the same as cash. Just because you made a Profit doesn’t mean that money is actually in the bank. You’ll want to dive into your Cash Flow statement to better understand the difference and how to maintain a healthy cash position. Watch this space!