Profit & Loss Statement: A Guide for Small Business Owners
Three financial documents are essential for both small businesses and large corporations. These three statements are:
- The Profit and Loss Statement
- The Balance Sheet
- The Statement of Cash Flows
These statements help both business leaders and investors evaluate the financial health of the business. Of the three, the income statement is the most reviewed and scrutinized. You should become very familiar with the different sections of the statement and how to use it as a tool for making decisions. We will address the following topics in our discussion of the profit and loss statement:
- What exactly is a profit and loss statement?
- Why is the profit and loss statement so important?
- Breakdown of the different sections of the profit and loss statement
- Example of a profit and loss statement
- Guide to analyzing the profit and loss statement
What exactly is a profit and loss statement?
The profit and loss statement has many other names such as "Income Statement," "Revenue Statement," "Operating Statement," or "Statement of Financial Performance." The profit and loss statement provides information about the company's revenue, expenses, and net income for a period of time. Companies typically create this statement on a monthly, quarterly, or annual basis. The length of the statement depends on the size of the company and the details desired.
Why is a profit and loss statement so important?
Business leaders use the profit and loss statements to determine if a business is trending toward profitability or a loss. The layout of the income and expenses helps business owners quickly identify necessary changes in the push towards profitability. The income statement can help in the following decisions:
- Can I afford to hire more employees?
- Would a move to a bigger office increase revenue?
- Are we proficiently utilizing the office space we have now?
- Should the company consider tax planning?
- Is our current growth strategy sustainable?
To be able to prepare an accurate profit and loss statement, you must maintain meticulous accounting practices. Accuracy is absolutely critical to assist with long-term and short-term business planning. Investors will want to know if the business is currently profitable and if it is sustainable. Public corporations must provide a series of statements to comply with General Accepted Accounting Principles (GAAP).
Breakdown of the Different Sections of the Profit and Loss Statement
Many small businesses use an accounting service to prepare their financial statements. It is critical that the business owner fully understand the different sections of the profit and loss statement.
1. Revenue
The Revenue section details the total income is generally broken down by revenue type:
- Sales
- Income received by selling assets
- Checks received from a tax overpayment
If you wish more of a breakdown of the sales, you might subdivide this section into the specialized areas of sales. It is essential to know the source of the revenue, and by having it broken down, you can easily track the changes in a specific source of income. This analysis will help you determine if sales need to increase to promote profitability.
2. Cost of Goods Sold (COGS)
The Cost of Goods Sold (COGS) is a critical section of the Profit and Loss Statement if you sell a product. It is essential to know the cost to manufacture or purchase your products. The COGS details the materials, labor, and machinery to make your product. It will help you determine if you buy or manufacture in larger quantities will you benefit from economies of scale. Sometimes you want to offer a discount to a new vendor to entice a more significant purchase; the COGS section will allow you to determine how much of a discount to offer and still remain profitable on that product. The Costs of Goods Sold (COGS) section will enable you to perform this type of analysis.
3. Gross Profit
The formula for gross profit is, subtract revenue less COGS:
- Revenue – COGS = Gross Profit
The gross profit section is crucial to determining if your product costs are too high and reduce the company's profitability.
4. Operating Expenses
The Operating Expenses (OPEX) section details the expenses of running your business that is not related to COGS. Operating expenses include:
- Payroll
- Travel
- Training
- Building Leases
- Utilities
- Equipment Purchase
- Hardware and Software
- Advertising
- Cell Phone and Internet Service
Each of the operating expenses should have its own sub-category. It is essential to look for ways to minimize operating expenses so that this section is very relevant to that task.
5. Depreciation
Your company likely has assets, such as a building, vehicles, or equipment. These assets would be depreciated at a specific rate and time period. Depreciation is used to allocate the cost of an asset over that asset's useful life and accounts for that asset's decline in value. Depreciation is typically not listed on a monthly basis, and it is included on the annual profit and loss statements. Depreciation can have a significant impact on taxes and is a valuable tax planning tool. Minimizing taxes is crucial to the longevity of any business. If you want to minimize your taxes, we highly recommend working with a firm that offers Tax Planning. Taxes are a complicated field, but a professional Tax Planner can significantly affect the bottom line.
6. Earnings Before Interest and Tax (EBIT)
You arrive at Earnings Before Interest and Tax (EBIT) by subtracting Operating Expenses from Gross Profit:
- Gross Profit – Operating Expenses = Earnings Before Interest and Tax
Earnings before interest and taxes (EBIT) is an indicator of a company's profitability before interest and taxes. The two following sections, Earnings Before Taxes (EBT) and Earnings Available to Shareholders, will allow you to analyze the impact of interest and taxes on the bottom line.
7. Earnings Before Tax (EBT)
You calculate your Earnings Before Tax (EBT) by subtracting COGS, Operating Expenses, interest, and depreciation from revenue:
- Revenue – COGS – Operating Expenses – Interest – Depreciation = Earnings Before Tax
Interest refers to any financing your company received that it must pay off. These are typically more significant expenditures such as remodeling, constructing a new building, or purchasing vehicles. Earnings Before Tax is an excellent indicator of business performance before the impact of taxes. The following section is only included if the company is responsible for taxes, such as a C Corporation. In other types of companies, such as an S Corporation, taxes are seen on the individual shareholder's return.
8. Earnings Available for Common Shareholders
Earning Available for Common Shareholders shows the company's total profit after taxes. If the company is listed as an S Corporation and the impact of taxes is seen on the individual return, you may want to refer to our tax forms library. This is the available profit that can be used to pay dividends to shareholders. This section is not necessary if your business does not have investors.
9. Net Income
This is typically what is referred to as the "bottom line." It is called that because it's the bottom line of the profit and loss statement and perhaps the most critical line. Net income indicates the net profit or loss, considering all income and expenses, including interest and taxes (if appropriate). Ideally, you want the Net Income to be as high as possible.
Sample Income Statement
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INCOME STATEMENT |
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For the Period Ending December 31st, 2020 |
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Accrual Basis |
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Revenue |
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Sales Revenue |
900,025.10 |
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Other Income |
426.18 |
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(Less Sales Returns & Allowances) |
($211.11) |
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Total Revenue |
$900,240.17 |
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Cost Of Goods Sold |
155,213.18 |
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Gross Profit |
$745,026.99 |
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Operating Expenses: |
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Accounting |
2,511.23 |
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Advertising |
25,645.92 |
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Amortization |
1,555.26 |
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Bad Debt |
1,123.57 |
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Business Meals |
5,462.33 |
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Depreciation |
52,123.55 |
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Employee Payroll Taxes |
15,435.22 |
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Employee Wages |
129,425.66 |
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Entertainment |
2,543.68 |
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Insurance |
2,487.45 |
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Interest Expense |
12,556.48 |
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Miscellaneous |
257.56 |
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Rent |
24,589.00 |
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Research & Development |
12,556.00 |
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Software |
4,567.55 |
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Telephone |
2,556.89 |
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Utilities |
7,958.25 |
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Web Hosting |
566.55 |
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Vehicle Expenses |
12,589.66 |
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0.00 |
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0.00 |
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0.00 |
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0.00 |
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Total Operating Expenses |
$316,511.81 |
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Net Income Before Taxes |
$428,515.18 |
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Less Income Tax Expense |
0 |
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Net Income |
$428,515.18 |
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Analyzing the Profit and Loss Statement
The most critical use of the profit and loss statement is for analysis, and it should be used to analyze new business strategies and refine existing ones.
What if my company made money?
Even if your company made a profit, it is not time to relax. You should still analyze the profit and loss statement. The goal of every business leader should be to improve the company's profitability continually. If your company did make a profit, it is time to determine how best to allocate those profits. Some of your options include:
- Re-investing the money in the increased profitability of the company
- Savings- Create a business savings or investment account
- Increase salaries or grant bonuses for all or essential employees
What if your company made less money than the previous year?
In the corporate world, corporations are under tremendous pressure to have more significant profits every year. Investors tend to panic when a company doesn't increase its profit over the prior year. But just because your company does not increase its profit over the preceding year doesn't mean your business is in trouble. For example, let's say your business made $25,000 in 2019, and then it made $22000 in 2020. Sure, the business earned $3,000 less, but $22,000 is still not a bad profit. It's possible the reduction in profit was a result of uncontrollable economic circumstances, like an overall recession or supply shortages. It would be best to monitor these downward trends over the next few years. If monthly net income for the first quarter of 2021 indicates that your business is on a trajectory to have a profit of $30,000 for 2021, things are looking up. However, if the company is projected to have an income of $18,000, revenue continues to trend down. You might need to make some significant changes in your business to curb the decline.
What if my company lost money?
First off, don't panic! Even large, very successful corporations have losses. Use the profit and loss statement as a tool to gain a more detailed understanding of what's keeping your business from being profitable. It might need to generate more sales or active reduce your operating expenses. Your Cost of Goods Sold may be too high. Whatever it is, remember that a profit and loss statement is a tool to analyze the profitability of your business. It is not unusual for a new company to take a year or more to become profitable.
Bookkeeping and Accounting Services Tailored to Your Small Business
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