Being an enterprise owner, one needs to make crucial decisions that affect the profitability and market reputation of the business. Should the operations be continued or should the business be sold now? Is merging with another business viable? What is the right time to look for investors? Or Should you try to self-fund a little longer?
These are some very common dilemmas that founders have to encounter— but to pick the right path, one needs to ascertain whether the business is financially stable or not. A profit and loss statement helps in assessing that.
A P&L statement indicates the financial health of an organization. It compares the total revenue of the business against its debt and expenses. Essentially, all of the company’s expenses are subtracted from the income.
A P&L statement is also known as an income statement, earnings statement, revenue statement, operating statement, statement of operations, and statement of financial performance.
The basic terms :
Before diving into the basics of understanding, creating, and using a P&L statement, there are a few basic terms that one must know. The first is net income, which means the income of the company after deducting all expenses.
Operating income is another key term that refers to the income derived from primary business activities.
Why is preparing a P&L statement important?
Many times, the law requires certain companies to prepare P&L statements for continuing their operations. A P&L statement also helps a company’s management team to understand the business’s net income, which is useful in decision-making processes. For example, a businessman would consider the profitability of the business to justify renovating their building or expanding in other ways.
A business also needs to furnish a P&L statement while applying for small business loans or while seeking funding from investors. Lenders and investors evaluate the net income and operating income against the expenses, debts, and taxes to ensure that the business is viable and worth providing financial assistance to.
Following are the six key areas that are included in a P&L statement:
Revenue
The revenue section of a profit and loss statement covers all incomes earned by the business from the day-to-day operations including the receipts from the sale of goods and services, as well as other sources of income, such as the interests, earned, etc.
Cost of goods sold (COGS)
The cost of goods sold is the amount spent on materials that are essential for operating the business. For example, the purchase of raw materials and machinery required to manufacture products, and customers.
If you own a bakery and charge $10 for a cake, $10 is not your profit. You need to deduct the costs of flour, sugar, and all ingredients along with the utensils used oven, baking tray, etc.
However, Indirect costs like rent, accounting, or marketing, that are not expressly associated with the creation of services and goods are not part of COGS.
Operating costs
Under this bucket, the amount spent on resources to maintain daily business operations is calculated. This includes spending for:
Employee salaries
Business rent and commodities (business phone, office space, etc.)
Depreciation of assets and equipment (computers, office furniture, vehicles, etc.)
Administrative fees (insurance, office supplies, and other items not directly connected to specific goods or functions)
Gross profit (or loss)
Gross profit refers to the income of the business earned after subtracting COGS.
This implies that Gross Profit = Revenue – COGS
Operating profit (or loss)
Operating profit is the total that the business gets after deducting COGS as well as additional expenses. Amount spent on rent, salaries, admin fees, etc is deducted from gross profit in order to calculate the operating profit.
The formula:
(Revenue – COGS) – Operating Costs = Operating Profit
Net profit (or loss)
Net profit is the amount the business earned minus COGS, operating costs, debt interest, and taxes. In other words, it is the total revenue minus all costs and signifies what eventually ends up in the company’s coffers.
To calculate taxes and interest from debts etc are subtracted from the operating profit. The formula:
Operating Profit – (Debt Interest + Taxes) = Net Profit
If the result comes out to be negative, you’d have a net loss instead of a net profit.
Conclusion
Creating correct P&L statements helps in assessing the company’s financial position and gives investors a good overview of its financial performance. Keeping a good track of the statements also helps in spotting patterns as well as projecting future earnings.
The purpose of reading a P&L statement is to determine the profitability of a business. The P&L statement has to be reviewed and analyzed line by line to identify if the company is incurring losses or running at profits.
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