If you own a business, you're likely aware of the importance of a profit and loss statement. Profit and loss statements help you analyze how your business performs over a specific period, usually by quarter or accounting year. While understanding a profit and loss statement may seem challenging, becoming familiar with the creation process and common terminology will benefit your company's future.
What Are Profit and Loss Statements?
These financial statements are also called income statements or P&L statements. But what is the profit and loss statement definition? Businesses worldwide use profit and loss statements to show revenue, expenses, and net income over a specific period, unlike a balance sheet definition focusing solely on a particular point in time. Every business is different, meaning a profit and loss statement will be created at a chosen time that suits a company and its unique needs.
Commonly, businesses update a profit and loss statement each quarter and after each accounting year. Business owners have access to numerous accounting software programs that simplify creating a profit and loss statement. However, it's helpful to become familiar with the profit and loss statement format to adequately assess and prepare your profit and loss statements with or without software programs. A profit and loss statement is divided into five parts; learning what is included in each section is vital for accuracy.
- Revenue: The revenue section on a profit and loss statement refers to the total sales made in the specified period and any money received from selling property, equipment, or tax refunds.
- Cost of goods sold (COGS): When a business sells a product or service, the total earnings aren't the price the customer pays. As a business owner, you're likely aware that the cost of materials and production time must be accounted for.
- General expenses: Rent, computer equipment, office supplies, and utilities can all be accounted for under the general expenses section of your profit and loss statement. These are indirect expenses as they don't contribute to making products or delivering services.
- Other expenses: Interest, taxes, sales of assets, and restructuring costs can all be accounted for under the other expenses section of your profit and loss statement. These are considered non-operating expenses as they don't directly relate to the main operations of your business.
- Net income: After plugging all the numbers into your profit and loss statement, you'll determine how much money remains after all expenses are subtracted from your quarterly or annual revenue. Net income will help you decide, regardless of whether you've profited or lost during the specified time frame.
However, not every expense or revenue is required to be recorded in a profit and loss statement. Expenses on assets and cash injections like long or short-term business loans are typically excluded.
Profit and Loss Statement Terminology
There are many moving parts of a profit and loss report. Becoming familiar with common terminology will help you categorize your expenses correctly and create an accurate profit and loss statement for your chosen period.
- Expenditures: The total purchase price of any goods and services purchased during the specified time frame can be entered in the expenditures section of your profit and loss statement. Total expenditures should be easy to determine, but becoming familiar with the various types of expenditures is recommended to ensure all data is included.
- Gross profit: As a business owner, you're curious about how much you've profited in a quarter or year. Gross profit refers to the amount your company has made after any costs for making and selling products or providing services are considered. You can determine your gross profit by subtracting COGS from your total revenue.
- Operating expenses (OPEX): All costs associated with running your business, such as travel, payroll, advertising, and more, can be accounted for in operating expenses. However, it's essential to determine whether they're COGS or OPEX. The company's size and type usually specify the number of operating expenses a business has.
- Depreciation: Did you know the moment you purchase something new, it loses a portion of its value? They all lose value over time, whether machinery, equipment, or other essential business items. You must account for depreciation in your profit and loss statement, as these numbers can be counted as a loss come tax time.
- Earnings before interest and tax (EBIT): Another common term for EBIT is the operating profit, which determines your company's profitability. You can calculate EBIT by subtracting OPEX from your gross profit.
- Earnings before tax (EBT): Are you curious about how your business performs compared to others? EBT makes that simple as it measures your company's financial performance. You can calculate EBT by subtracting COGS, OPEX, interest, and depreciation from your total revenue.
- Earnings available for common shareholders: Your company might have investors, or you might complete owner's draws in place of a salary. If so, the earnings available for the common shareholder's section of your profit and loss statement will show a net after-tax profit while accounting for any dividends for preferred shareholders.
- Owner's draw: Business owners commonly take money out of company revenues for personal use as this is a way to pay themselves and alleviate the need for a salary.
Reading a Profit and Loss Statement
An initial glance at a profit and loss statement example may make it seem daunting. However, business owners worldwide have recognized the value behind sectioning the statement into three categories as this eliminates confusion and complexity.
- Revenue: Taking time to determine how much money your business makes in a quarter or accounting year will help you identify total sales, revenue, and income for a specific time frame. This is usually the first section of a profit and loss statement.
- Expenses: You'll identify how much your business requires during a quarter or accounting year to receive profit. In this section, you'll include general and other expenses purchased materials with a business line of credit, and more. This is usually the second section of a profit and loss statement.
- Net income: Determining your net income for a quarter or accounting year is the sole purpose of a profit and loss statement. Your company's net income will be calculated once all numbers are entered into your P&L statement to help you identify if your business operated at a profit or loss for the specified time frame. This is usually the third section of a profit and loss statement.
After sectioning your profit and loss statement into three categories, each category is broken down into sub-categories so all essential numbers have a home. Once all required numbers are inputted, you can identify gross profit, operating profit, and net income. Your net income will help you determine whether your company operated at a profit or a loss for the quarter or accounting year. Remember, depending on your operation discovery, it may be time to increase revenues, cut costs, or both.
Preparing Your Profit and Loss Statement
Learning how to read and analyze your profit and loss statement is the first step, and once you've mastered this, it's time to start preparing them. Business owners have access to various accounting software programs like QuickBooks or Xero, making managing their books and preparing financial statements simple. Various online resources also offer business owners a profit and loss statement template. These can usually be found by searching "profit and loss statement for small business." If you work with a bookkeeper or accountant, these programs allow timely and efficient collaboration opportunities. However, based on your free time or company size, you may find it more beneficial to independently prepare profit and loss statements. If you choose to complete a P&L statement on your own, these are a few simple steps you can use as a guide:
- Prepare and determine your company's revenue for each quarter of the year.
- Identify your company's quarterly expenses to learn how much your business spent and whether they are categorized as COGS or OPEX.
- Take your company's overall expenses and subtract them from your gross profit. This will help you determine your EBIT for each quarter and the accounting year.
- Any taxes and interest should also be subtracted from your EBIT. Interest charges can be challenging to navigate, so guidance from an accountant with small business experience may be beneficial.
- Learn whether your company operated at a profit or a loss for each quarter and the accounting year.
Profit and loss statement preparation doesn't have to be complicated, and completing preparation on your own can be hugely beneficial. You'll not only learn more about your business operations, but you'll gain clarity as to what changes you can make within your existing business model to increase profit or avoid further loss.
How To Prepare a Profit and Loss Statement: Final Thoughts
Simply put, small business owners must recognize the importance of profit and loss statements. While public corporations are required to complete these statements, familiarizing yourself with the process will help you review your net income and identify areas of improvement or SMB financing options. It's recommended that small business owners complete a profit and loss statement regularly, so they can stay informed about how well their business is performing. You can also compare past statements to recent reports, which can help you see your company's progression and market evolution.