New business owners are often burdened with an endless number of tasks to keep their companies on track. This list of responsibilities includes keeping a close eye on critical financial documents such as a Profit & Loss Statement to ensure that the business is turning in a profit.
In doing this, it is very important for entrepreneurs to not only know what a P&L statement is, but to also learn how to excellently manage profits and losses. P&L management means making necessary actions to the company’s finances to increase business profitability.
However, a lot of new business owners are not completely comfortable with this task as they would rather spend their time focusing on ideas that could aid business growth, rather than poring over financial reports. This is usually because of a lack of understanding on how to review P&L statements or the explanations being provided to them are too complicated.
The first step in effectively managing a P&L statement is to thoroughly understand what it is and how to use this information to grow the business.
Defining Profit and Loss
Profit means making money, while loss means losing money. A profit is a financial benefit which is the surplus remaining after total costs are deducted from total sales. If this surplus is negative, this means the business is experiencing a loss. In order to keep track of a company’s profits and losses, a P&L statement has to be generated.
The P&L Statement Formula
P&L statements can show business owners what part of their business is generating more revenue and what expenses are draining the company’s cash flow. More importantly, it ultimately shows if the business is making money.
It may seem complicated to read a P&L statement at first but it is actually based on a very simplistic formula: Sales minus Costs equals Profit.
Even if the P&L statement runs ten pages long, the formula does not change. It is still going to be a report of the total cost of expenses of the business subtracted from the revenue the business generated during that period.
Managing the components of a P&L Statement
Although sales, costs, and profit can be referred to in different terms and sub-categorised in numerous ways, these three remain as the most important factors to understand.
Sales are typically placed at the top of the statement and can also be referred to as income or revenue. This can confuse a new entrepreneur who is not an accounting expert but these other terms are essentially synonymous with the amount of money the business is bringing in.
The sales column can also be subdivided into different categories to classify the specific sales channel the money is coming from.
For example, an electronics shop can categorise its sales depending on the type of products sold such as mobile phones, laptops, TV sets and accessories. All of these categories will have their own sub-totals that will be added to come up with the company’s total sales.
Sub-dividing the sales sources will greatly help business owners identify which products are the best-sellers, which are giving the most profits and which are underperforming. This can affect how much stock should be ordered, which products to retain and which ones to drop.
Constantly monitoring sales can also give business owners an opportunity to apply additional marketing and promotional efforts in case targets are not being met.
Costs are the expenses the business incur during a specific accounting period. There are infinite ways to subdivide cost but in the end, the total cost will still determine the final profit report. Here are some of the most common types of costs.
For businesses who sell products, it is useful to first identify the cost of goods sold or COGS to determine the gross profit. The COGS is the amount of money a business owner spends to produce or acquire the goods sold, while gross profit is total sales minus COGS.
For example, 100 pieces of shirts were sold which brought in a total revenue of £5,000. If it costs £2,000 to buy these shirts from the manufacturer, then this amount is the COGS. The gross profit will be £5,000 (total sales) minus £2,000 (COGS) equals £3,000 (gross profit).
Aside from COGS, the P&L statement should also reflect all other expenses that the business spends including rental fees, labour costs, maintenance fees, marketing costs, utilities and more.
In opening a new business, entrepreneurs need equipment to operate. There are business owners who prefer to purchase equipment at the onset as this can prove to be more cost-effective in the long run. However, there are also entrepreneurs who have limited capital which makes purchasing expensive equipment difficult so they would rather lease equipment.
There are different pros and cons of buying or leasing office equipment . Business owners must weigh these factors to decide what is more beneficial for them in the long run, but whatever that decision is, this will reflect differently in the P&L statement.
If an equipment is purchased then it is regarded as an asset and should not be included in the P&L statement as a cost. This purchase cost should instead be added in a separate financial statement called the balance sheet which shows the long-term assets, liabilities and equity of a company. What should be added in the P&L statement is a non-cash expense called depreciation cost. This is calculated by dividing the total cost of the purchased asset by the number of years the equipment is projected to be operational.
For example, if a company purchased a printer that costs £4,000 and is projected to be used for the next 4 years, the depreciation cost per year will be £1,000. This expense should be added on the annual P&L statement in the next four years.
On the other hand, if the company decides to get an annual operating lease for that same printer, then that rental cost should be considered as a straightforward expense in the P&L statement. The cost of the printer should not be reflected as an asset in the balance sheet.
There are also unexpected expenses a business may face. When preparing a forecast, it is wise to add 20% to the operating cost to allow for these expenses. This can include maintenance fees for broken equipment, credit card fees, utility issues, additional taxes, permit fees, and more.
Another example of an unexpected expense that is increasingly damaging businesses is cyber breach. A laptop security statistic has shown that two-thirds of UK business owners don’t think that they are vulnerable to cybercrime which makes it understandable why 58% of malware attack victims are categorised as small businesses.
When a cyber breach occurs, the unexpected cost involved in recovering from this problem can greatly impact the financial standing of a business. Having this expense reflected in the P&L statement can then help business owners to realise the importance of enforcing advanced security measures to avoid similar issues in the future.
It was already discussed that total sales minus the COGS will amount to gross profits. The next step will be to deduct all the other costs from the gross profit to get the net profit.
The net profit is the final amount on the P&L statement. If this is positive, then the business is making money or having a profit. A negative figure means that the business is spending more money than it is making.
When a business is enjoying high profits, business owners can use this as a signal to increase their product offerings or extend their market reach. However, if the business is losing money, comparing P&L statements can also help in knowing what expenses to cut back.
Effective P&L Management
Even if a business employs a dedicated accountant, it is still important for new business owners understand how to strategically manage profits and losses. This is because effective P&L management is what will influence business decisions and help business owners create strategies to improve and become successful.
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