"The first rule of business is to survive and the guiding principle of business economics is not the maximization of profit, it is the avoidance of loss." -Peter Drucker
There are many complex concepts of accounting, business & finance that cannot quickly be grasped by individuals who do not have experience or secular training in these sectors.
It is certain that many accounting principles are difficult to understand in the beginning, however, on the other hand, various individuals do not attempt to learn valuable accounting or business related notions such as filling out an invoice, calculating business expenses or doing income taxes due to the fact that they believe it is best left to the professionals.
Nevertheless, there are many online resources and well-written articles in finance magazines that make learning the basic concepts of accounting a piece of cake!
Superprof is here to instruct curious individuals what a profit and loss statement is, how to read one and finally how to create one that can be used for future business ventures.
What is a Profit and Loss Statement?
A profit and loss statement, also abbreviated as a P&L statement, is a financial statement or document the briefly summarises the revenues, costs, and expenses that were incurred during a specific period. The particular period is usually a fiscal quarter or year.
The information included on a profit and loss statement offers precious information to readers about the company's ability or inability to generate profit by increasing revenue, cutting down on costs or doing both.
Depending on the business or geographic location, some refer to a P&L statement as an income statement, statement of operations, statement of financial results, earning statement or an expense statement.
There are three financial documents that every registered company or enterprise publishes quarterly and annually. The three papers are the balance sheet, the cash-flow statement and, of course, the profit and loss statement.
The income statement or P&L statement is quite similar to the cash-flow statement which shows changes in accounts over a specific period. The balance sheet is slightly different the previously mentioned statements and shows what a company owes and owns at a given moment in time.
Many people, who have no previous knowledge of accounting-based subjects or key accounting terms, claim that balance sheets and P&L statements are the same. However, this belief is entirely false. There are several differences between the two such as the following:
- The purpose of each report is quite distinct. For example, P&L statements are more specific asking if the company is even profitable? Whereas balance sheets are broader and reveal what the company owns and owes,
- A balance sheet tells the financial position of a company for one specific point in time whereas a P&L statement or sheet shows revenues and expenses during a set period of time.
Since profit and loss statements are well organised financial documents, there are a few main categories that can always be observed on a P&L statement. The following are examples of the commonly found types:
- Revenue or Sales,
- Cost of Goods Sold,
- Selling, General & Administrative,
- Marketing and Advertising,
- Interest Expense,
- Net Income.
A profit and loss statement is prepared based on accounting principles such as revenue recognition, matching and accruals, which make it different from the cash flow statement.
It is important to note that it would be extremely beneficial for entities to compare income or P&L statements from different accounting periods. The changes in revenues, operating costs and net earnings are significant figures that help business owners identify the financial health of their company.
By reviewing past P&L documents, financial advisors may quickly identify the facts that your company's revenues have increased, but the expenses are growing at a faster rate. This may be a great wake up call to cut down on unnecessary costs!
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How to Correctly Read a Profit and Loss Statement
As we have previously stated, a profit and loss statement tells an individual if their company is profitable or not. Defining a P&L statement is far more comfortable than correctly reading one because, for the majority of people, it looks just like a big jumble of numbers!
To avoid confusion and show curious persons that reading a P&L document is quite straightforward and easy to understand, we will provide a quick run-down and explanation of what each section means and how the numbers are determined.
The following are the various sections of a P&L statement and what they signify:
- Revenue: also commonly known as the "top line" of the profit and loss statement. This is the money that profitable companies are bringing in from sales and non-profit organizations from the money raised at fundraisers. This is the most critical aspect of your business due to the fact that your profits cover the costs of your expenses,
- Direct costs: also known as the cost of goods sold. These are the costs incurred when you make your products or deliver the services you offer. These direct costs depend on each business, for example, a company that manufactures hats would include the materials used to fabricate the lids such as wool and thread as part of their direct costs,
- Gross margin: this is determined when you subtract your direct costs from your revenue. Gross margin tells a business owner how much money you have left over to cover your expenses after you've covered the value of your product or service. The gross margin percentage is also featured on P&L documents which represent the number as a percentage,
- Operating expenses: theses usually include rent, salaries or benefits, marketing costs and utilities. It is important to state that these expenses do not include the costs required to make merchandise; direct costs cover merchandise not operating expenses,
- Operating income: this is known as the total income earned before interest, taxes, depreciation etc.
- Interest: this is only included if your company has to make interest payments on any loans on you may have,
- Depreciation: these are special expenses that have to do with the assets your company possesses. It is a well-known fact that with time assets lose their value and depreciate. This expense will be calculated and recorded in this section of the P&L statement,
- Taxes: no one likes to think of taxes, but guess what? They need to be paid, and in this section, an entity sets asides money their required taxes,
- Net profit: also known by many as the net income or "bottom line" of the profit and loss statement. To calculate your net profit, you start with the "top line" or revenue and subtract things such as direct costs, operating expenses, taxes etc. The number that you come out with is the net profit.
Who said reading a profit and loss statement would be difficult? After understanding each function or section of a P&L document, a person gains confidence and feels ready to create their own.
How to Create a Profit and Loss Statement
P&L statements are not only for multi-million-pound corporations but also for small businesses who want to have the necessary financial documents that will help them determine the economic prosperity and future of their enterprise.
It is important to note that there is required information needed to prepare a P&L statement. Certain things needed are the following:
- A transaction listing of all the financial transactions made with your business checking account and all purchases made with the business credit card,
- Even the receipts of all petty cash transactions need to be included,
- A listing of all sources of income such as checks, credit cards and payments need to be involved and can easily be found on a bank statement.
After all the required information has been found, business owners can start to prepare their profit and loss statement.
Firstly, your business revenue for each quarter of the year needs to be shown. Secondly, business expenses for each quarter are calculated. Thirdly, then the difference between sales and costs can be calculated to determine the total amount of earnings. Fourthly, the interest paid for debts is written down on the statement. Fifthly, list the taxes that need to be paid. Lastly, show total depreciation for the year and subtract.
After the six previously mentioned steps are completed, the number that you are left with is your business' net earnings or total profit.
Thanks to the technologically advanced world that we live in, many profit and loss templates can be found online and used to effectively create this significant financial statement.
Advantages and Disadvantages of Using a Profit and Loss Statement
Every single concept, theory, strategy and manufactured object have its advantages and disadvantages. Therefore, a profit and loss statement is no different. The P&L statement is commonly used in a business setting to track the financial statements of a company and analyse how the entity is performing.
Without further ado, we will review the advantages and disadvantages of the profit and loss statement. Here are the benefits that business professionals enjoy:
- Tracks business performance: the "bottom line" on a P&L statement is one of the best indicators used to determine the overall health of a business. Without a precisely written profit and loss statement, a financial expert or auditor might conclude that the entity is profitable but will never know for sure. To effectively track the economic prosperity of an enterprise, past P&L documents from specific periods can be compared and analysed to improve business transactions,
- Identifies financial trends: a P&L statement is an excellent aid for determining trends and forecasting or predicting future performance. Using past profit and loss statements from different quarters can help the business' financial advisors detect what the future holds. Through heedful examination, problems can be identified and rectified as soon as possible.
The previously mentioned examples are the advantages appreciated by many accountants, bookkeepers and finance professionals. However, just like anything else, there are some disadvantages. Here are a couple of drawbacks of P&L statements:
- A small piece of the puzzle: due to their convenience, many accountants and finance professionals have purely relied on profit and loss statements as the only picture of the health of the business. This can become a dangerous trap because there are many other documents and factors to consider. The balance sheets and cash-flow statements have equal importance in a business setting. For example, a balance sheet is an important document to show the overall health of a business concerning the ratio of assets to liabilities, or equity to liabilities. Lastly, let us not forget cash-flow statements that must be analysed to prevent any cash shortages.
- It's a lot of work: P&L statements require a lot of reporting of the financial data. Also, if a financial advisor or business manager spends too much time observing the profit and loss statements, an unrealistic picture of the business financial position is painted.
In conclusion, profit and loss statements can be read, understood and created by a wide variety of business, finance and accounting enthusiasts.
Learning more about accounting concepts and principles has never been so accessible primarily due to the incredible resources that are available online. So, why are you still waiting? Become a finance pro today!