Successful business owners are able to see the story behind the numbers when they look at their financial statements.
I always ask business owners if they review their financial statements, and I often get that deer in headlights look. I know looking at a bunch of numbers can be intimidating if you’re not sure what you’re looking at, but if you aren’t taking the time to look at your financials, how do you know whether your business is successful or not? How do you pinpoint the areas where you need to make improvements?
The P&L is arguably the most important financial statement for any small business owner, so if you’re not reviewing it, then you should start!
What is a P&L?
P&L is short for “profit & loss”, and is another name for the Income Statement. The P&L tells you how much money you made in a particular time period.
The basic formula for the P&L is: Revenue – Expenses = Income
This tells you how much you sold, how much of your sales were used to cover business expenses, and how much was left over for profit.
You’ll most commonly see the P&L by month, quarter, or year, although you can usually run it for any time period you want to see. I also recommend comparing your P&L to a prior period – you can compare to the same time last year, or look at a trend over time by month or year.
What are the important parts of the P&L?
Every P&L has the same basic parts:
Revenue/Sales: What you charge for your products or services, net of any discounts or returns.
Cost of Sales/Cost of Goods Sold (COGS): Any expenses you incurred to produce your product or service. Examples include inventory purchases, product shipping costs, and labor costs related to producing your products. If you’re a service-based business, this includes payroll for your employees if they do client-facing work.
Gross Profit/Gross Margin: This one is REALLY important! Gross profit is calculated as Revenue – COGS. If this number isn’t high enough, then you’re either not charging enough money or you’re spending too much to make your product or service. Gross profit needs to be high enough to cover your operating expenses and hopefully have some left over for you to pay yourself. I don’t care how much revenue you have – if you have no gross profit, your business isn’t going to be successful. And even worse – if it’s negative, that implies that every time you sell something you’re actually losing money because it costs you more to produce your product/service than you get for selling it!
I actually prefer to look at a company’s gross margin instead, which is gross profit / revenue. Gross margin shows the gross profit as a percentage of revenue – in other words, how much revenue is left over after you pay for all your production costs?
Let’s say that a company’s gross profit is increasing – that’s good, right? Not if gross margin is decreasing! If this is the case, then the company isn’t making as much money off its sales. On the other hand, a company could have a higher gross margin on the same level of sales, which means it is making more money without increasing sales, and that is an indicator of success!
Operating Expenses: You may also see operating expenses referred to as overhead expenses. These expenses include everything else you incur to run your business that isn’t directly tied to producing your product or service. This most commonly includes things like rent, marketing, professional fees, dues and subscriptions, payroll for administrative employees, insurance, and office expenses.
One thing that isn’t included in this number is how much you pay yourself, if you have an LLC or sole proprietorship. See our post on how to pay yourself for more info.
Operating Income: Operating income (or operating profit) is calculated as Gross Profit – Operating Expenses. This number is a good indicator of the overall health of your business because it includes all the business expenses you incur on a regular basis. This metric tells you whether you’re making enough money to cover running your business day to day.
Other Income/Expenses: This section of the P&L includes nonoperating, unusual or infrequent transactions, such as credit card rewards or insurance claim reimbursements. A lot of companies also put interest expense and depreciation expense in this section because they are usually excluded from the most commonly used profit measures. This section is likely not to be used all that often by many businesses.
Net Income: This is your bottom line – how much money did you make (or lose) after all your expenses? Ultimately you want this number to be high enough for you to 1) invest extra funds back in your business so you can grow, and 2) pay yourself!
What is the P&L used for?
For starters, you (or your tax preparer) will use the P&L to prep your tax return. But please, don’t hand over your P&L and stop there!
The main things that I look at when I am reviewing a P&L are 1) profitability and 2) trends.
Here are some of the questions you can ask yourself as you review your P&L:
- Is revenue increasing or decreasing? How am I doing compared to last month/last quarter/last year?
- If you have more than one product/service, which one brings in the most money? The least money?
- Are expenses increasing or decreasing?
- Are there any expenses that you could cut back on? Any that have grown out of control?
- Is gross profit high enough to cover operating expenses?
- How is gross margin trending over time? Do you need to raise prices?
- Is net income high enough to pay yourself? Do you have any money left to save or invest in the business?
Once you get in the habit of updating your books, take a few minutes and review your P&L and understand the story of what’s happening in your business. If you’re using any soft of accounting software, there should be a P&L report available for you to run. If you’re using Excel or Google Sheets you may have to do a little work to pull it together, but the effort it worth it because the P&L is really the most important financial statement for most small business owners.