What is a Profit & Loss Statement?
The Profit and Loss report may be referred to as Income Statement, Profit and Loss Statement, Statement of earnings or P&L. It makes up one of the key reports in a set of Management Accounts.
The P&L provides a view of all sales (or income/turnover/revenue), costs of sale, administrative (or operational) costs and your overall profitability for a period in time; usually annually, quarterly or monthly.
The Basics of Profit & Loss Statement
Turnover refers to the sales generated by the business, but sometimes it is referred to as income or revenue. There are various terms because of regional differences in accounting terminology around the world and specific business differences depending on where the turnover comes from. For example, some businesses generate through selling to customers, some also gain income through grants and some through interest on investments or savings. It’s because of this that these terms are often used interchangeably.
Cost of Sales
Cost of Sales refers to the cost associated with making a sale. An example might be an organisation that delivers onsite training using various subcontractors, they may have a transaction cost from the payment through a payment provider like Stripe, the cost of the subcontractor to attend the training, perhaps they also have to cover the subcontractors travel and the cost to book a hotel conference room. All these costs only happen if the sale is made so they are classed as Cost of Sales.
However, some costs are due whether you make a sale or not, for example, in order to operate under the organisations overall brand they will need insurances such as public liability insurance which will need to be paid up front in preparation. Email addresses, web domains, professional relationships (legal and accountancy) and internal software all have costs that need to be paid irrelevant of whether sales are made. These are Administrative or Operational costs.
Gross profit is the amount left after taking your Costs of Sales away from your Turnover.
Gross Profit = Turnover - Cost of Sales
Net profit is the amount left after taking your Cost of Sales AND your Administrative costs away from your Turnover.
Net Profit = Gross Profit - Administrative Costs
Structuring Your Profit and Loss
A huge oversight many business leaders make is that they don’t customise their P&L. This means it will look something like this:
This is okay and we can definitely learn from this, but it lacks its full potential.
Businesses should always customise their P&L (with the help of an accountant) so they can obtain the information they need from the report. A good first step is to focus on customising your sales and cost of sales figures into some reasonable categories.
As an example, an ecommerce business may sell through various channels such as on their own website, through Amazon and maybe even some trade sales. Some useful information will be stored on other platforms (like Amazon), but seeing the breakdown of these could help more.
We have the same P&L here, but we’ve now split our ‘Sales’ into ‘Amazon Sales’, ‘Website Sales’ and ‘Wholesale Sales’. At this point we can see that there are not a lot of sales coming through Amazon, this could be due to it being a relatively new revenue stream, or there could be an issue, but there is definitely a story behind this. It’s this story that’s important, understanding the stories behind the numbers helps us to have a greater understanding of our business and can inform our decision making going forwards.
And we can do the same with Cost of Sales. Here is one example of how these could be broken down:
You can see that the cost of sales have become far more valuable than just a ‘Purchases’ category. And more categories could be added to show shipping in costs, affiliate commissions, packaging and more.
By now, you can see that adjusting the categories on your profit and loss can help you have more financial clarity and help you understand the stories behind the numbers.
As a business leader, there should never be an occasion where you don’t understand what the numbers on your P&L mean, where they came from and the story behind them.
There are also other ways to structure your profit and loss, including by using some form of analysis to ‘tag’ transactions to help you to report on them easier at a later date. In Xero these are called Tracking Categories, in Quickbooks there is Locations, Classes and Tags. If you remember, I started by saying it’s important that your reports help answer your questions Using these ‘tagging’ methods can allow you to take your P&L to the next level and report across business units, departments, or income streams. For example, the ecommerce business may split down their Profit and Loss based on the country they sell in, so they can identify the proportion of sales and the associated costs by country. In the example below we’ve shown a very simple split which shows that all wholesale sales are in the USA, but no costs are attributed currently, perhaps there is a data error where core costs to create the goods being sold aren’t being recorded such as a missing invoice. So now, we are not only identifying stories about our business, but also the quality of our data and how reliable it is to base business decisions on.
Taking It One Step Further
Once you’ve spent time structuring your data, you can begin to analyse your P&L in more detail. There are a myriad of ways to do this, but here’s a few to get you started.
- Using the P&L to underpin metrics - By looking at the Gross Profit you can work out your Gross Profit Margin (how much profit - as a percentage - that you make on sales after taking into account direct costs). Please refer to our Financial terms blog for more info. If this Gross Profit Margin (GM) is relatively high then it may be that you have a better business model, if it is very low then there could be an issue. For example, it could identify that pricing is too low, or the cost to create a given product is too high.
- Using the P&L to do benchmarking- We’ve already mentioned about gaining metrics from the P&L; some, like Gross Margin, can often be compared with other companies in your industry in order to benchmark how efficiently you are running your business. Investors often look at figures like this to get a gauge of how you stack up to your competition. But you can also benchmark based on overall net profitability or the costs in a particular area.
- Using the P&L to compare periods - A P&L will show details for a given time frame or period, it’s then possible to compare this with previous performance. For example, you could compare this year's results with last years, or November this year with November last year. This can help spot trends and patterns, especially if a business is seasonal in nature.
- Obtaining EBITDA - EBITDA or Earnings Before Interest Tax Depreciation and Amortisation refers to your net profitability before these items are used to make adjustments. It’s often used to get to the ‘real’ profitability of a business so someone can identify its underlying value. In our example P&L this EBITDA figure may be represented by the line Profit on Ordinary Activities Before Taxation, but it’s important to check that none of the ITDA parts of EBITDA are represented in this figure and to note that different software may call this figure by a different name.
There are many more ways to use the Profit and Loss Report to understand your business in more depth. It’s worth speaking to your accountant to learn how to read and understand your profit and loss report.