by Christopher Freeburn
Small business owners quickly learn about the necessity, particularly in this economy, of having a well thought-out business plan, doing the right amount of market research, and keeping excellent records. Good bookkeeping and adherence to proper account forms and standards often distinguish small businesses that succeed from those that fail.
Part of the importance of maintaining good financial records is that it permits the business owner to see exactly where his or her business stands at any given point, to observe in detail its strengths and weaknesses, and to make sound judgments about the business’s likely future results. This allows the business owner to quickly address problems in the business and plan accordingly for changing market conditions.
Among the most important financial metrics that a small business owner should pay strict attention to is the business’s profit/loss, or P/L, statement. Simply defined, the P/L statement compiles the business’s cash inflow and outflow over a specified period of time, deducting the latter from the former to tabulate the business’s net profit or loss for the period. P/L statements provide a far better indicator of a business’s overall health than other financial statements—like cash flow, for instance—because P/L statements show, directly, the business’s overall viability.
P/L statements have a specific and simple format. Since the underlying formula for determining profit or loss is straightforward—revenue minus expenses—the P/L statement just adds up those items that bring revenue into the business, and then those that take money out of the business, and performs a little subtraction.
The proper components of a P/L statement are as follows:
- Sales revenue. In this section of a P/L statement, the business should identify any source of revenue for the firm. Revenue can be stated in aggregate, but it is often more useful to breakdown various sources of revenue if the business includes more than one geographic area, industry, or income stream. (A business might lease out equipment or space, for example, in addition to selling goods or services.) On the P/L statement, the various categories of revenue are listed and then added together to create a subtotal.
- Cost of sales. In this section, all costs involved in producing the goods or services by the business are stated. This includes the cost of materials, supplies, labor (for those working directly on the products or services), and money spent on equipment or leases.
- Gross profit/loss. This figure is determined by simply subtracting the cost of sales from the sales revenue. If the difference is positive, the business is making money and records a gross profit; if the result is negative, then the business is losing money. A gross profit/loss percentage may then be obtained by dividing the gross profit/loss by the total sales revenue.
- Expenses. Into this section go all the overhead costs of running the business that are not specifically related to producing the goods or services that the business sells. These include the salaries of employees not directly working to produce the business’s products, rent, utilities, insurance, distribution, marketing, office supplies, accounting and legal expenses, maintenance, and any taxes paid by the company.
However, it’s important to note that many businesses exclude a few items from their expenses to calculate another net income metric known by the acronym EBITDA. This term, which stands for earnings before interest, taxes, depreciation, and amortization, is often used to compare the profitability of various companies without having to account for differences in accounting methods or financial investments.
Net profit/loss. This figure is determined by subtracting the expenses noted above from the Gross Profit/Loss subtotal. It is entirely possible for a business to have a gross profit, but a net loss, meaning that the sales revenue is sufficient to cover the creation of the products sold by the business, but insufficient to cover the administrative costs of running the business. Depending on the situation, this can suggest that administrative costs have been allowed to run too high.
The value of P/L statements
P/L statements are important for small businesses because they cast a clear light on the enterprise’s actual financial functioning. It is possible for some small business owners to become too devoted to measuring cash flow, sales numbers, or other financial indices of the business, while forgetting the most important data of all—whether or not the business is actually making money. Keeping a close eye on the P/L statement will bring that into sharp focus.
Many small businesses actually lose money during their initial years of operations. Building sales revenue is not an instantaneous process for many firms and prudent entrepreneurs often anticipate several years of net losses before the business starts making a profit. Nonetheless, P/L statements allow entrepreneurs to examine the underlying engine of their business in a structured and efficient manner. For a business to succeed in the long run, it must produce profits eventually and the only way to know if your company is profitable is to be watching your P/L statement.
P/L statement resource box:
For more on why a company may or may not want to monitor EBITDA as well as their P/L statement, you can visit this resource.