Income Statement - Profit and Loss
An income statement or profit and loss account (P&L), revenue statement, earnings statement or statement of operations is your businesses statement of revenues and expenses during a particular period. It demonstrates your ability to generate profit and can be used to identify methods of increasing revenue and reducing costs.
The income statement / profit and loss account begins with an entry for revenue and subtracts from revenue the costs of running the business, including cost of goods sold, operating expenses, tax expense and interest expense. The "bottom line" is your net income or profit.
All businesses have to prepare a Profit and Loss account as part of their annual accounts. However, this calculation is also a valuable part of your monthly management accounts. A Profit and Loss account shows exactly what has happened in your business in terms of income and expenditure during a specified period.
A Profit and Loss account shows:
- The sales turnover for the period.
- Any other income.
- The expenditure for the period.
- The level of profit (or loss).
- How the profit has been divided.
Income Statement / Profit and Loss - Key Terms
This figure shows the actual amount of sales for the period, excluding sales tax (VAT). It does not reflect the cash received from customers, since some payments may still be outstanding. Indeed, businesses may not receive cash for their sales until 30 or 60 days (or sometimes even longer) after the sale is made. The sale is recorded immediately on the Profit and Loss account, although the cash is not available for use by the business until it is received.
Cost of sales
The costs of sales, sometimes known as 'direct costs', are those that can be directly attributable to the sales. The direct costs will vary depending on the level of production. In other words, they should reflect raw materials, direct labour and subcontract costs for the products or services actually sold during the period.
There may be stock purchased during the period that was not used; this will be shown on the balance sheet but not charged to the Profit and Loss account. Raw materials may also have been used which were bought in a previous period. The cost of those materials will be included in the direct costs. Materials purchased but not used will be shown in the stock figure on the balance sheet.
It is important to watch out for purchases of materials or subcontract work that have gone into sales made during the period, or are included in stock at the period end, but for which your business has not yet been billed. This applies to any costs incurred where invoices have not been received. Ideally, your business will not prepare its accounts until all bills have been received. However, when producing management accounts, an estimate of these costs may have to be made in order to give a profit figure that is as accurate as possible.
Expenditure on overheads, also known as 'fixed costs', is usually recorded immediately on the Profit and Loss account, but you may not actually pay for goods or services until well after they have been provided. This is known as 'accrued expenditure'. Some payments, however, may represent pre-payment. For example, rent or insurance paid in advance may partly relate to the current period and partly to the following period.
If you have set up a limited company, your salary, together with the salaries of your staff and any other directors, will be treated as expenses. However, if you are self-employed (as a sole trader or partner), the money available to you is the profit - the sales revenue less all the costs but not including your drawings. You will need to draw money from your business on a regular basis to cover your living expenses. Your drawings are simply an advance against profit and aren't allowable as a business cost. You are taxed on all the profit. However, for the purpose of calculating your business' actual costs, it makes sense to treat your drawings and any income tax as overhead costs.
Depreciation is always charged to the Profit and Loss account to show that the use of fixed assets is one of the costs of generating income. It is an allocation of the costs of fixed assets over their useful, or income generating, lives.
Depreciation does not involve the receipt or payment of cash; it is a book entry. It's important, however, that money is put to one side to cover depreciation, or you may not have the required resources when you do need to replace equipment. If depreciation is high relative to payroll costs, your business is 'capital intensive'; if the payroll costs are high relative to depreciation, the business is 'labour intensive'.
Calculating Year-To-Date Profits
Excel 2013 Essential Training
Direct costs are deducted from sales the figures to give gross profit, also known as the 'contribution', because it contributes towards paying for your business' overheads (and once the overheads are paid, it contributes to profit).
This allows you to calculate your business' gross profit margin: this is simply the gross profit divided by sales, and is usually expressed as a percentage.
Overheads are deducted from the gross profit to give the net profit, sometimes referred to as profit before interest and tax (PBIT) and sometimes as trading or operating profit. In turn, the net profit margin is the net profit divided by sales and is expressed as a percentage.
It is important to keep an eye on both your gross profit margin and net profit margin, as dramatic reductions in either could be a sign of trouble.
Note that some businesses show the deduction of interest, particularly for long-term loans, after calculating profit. This can be helpful as it makes it easier to calculate return on capital and draw conclusions about a business' performance. If you decide to show interest after the net profit, don't forget to include it in your costing and pricing calculations.
It is usual at the bottom of a Profit and Loss account to show an appropriation account. This is an explanation of how the profit is divided. Profit can be divided in three ways: to the shareholders or owners (as dividends or drawings); to the Government as tax; or it might be retained in your business to use as working capital or to buy equipment or other assets.
Income Statement / Profit and Loss - Usage
Your business already has a position in the marketplace,
whether you know it or not. People have a perception
about who you are, what you offer, and how it compares
to your competitors.
They might think of you as the “cheapest guy in town”, the
overpriced supplier, the high-end technical provider, the
value provider, the only one they’d ever call, the one
they should avoid at all costs, etc.
Some business owners allow their customers and competitors
to position their business for them. The market learns what
they know about them from competitors ads, word-on-the-
But, don’t you want to have a say in how people think
about you and your business? Don’t you want to do
work you enjoy and work with clients you like?
Positioning is what sets you apart from your competitors.
It is what makes a prospect choose to work with you rather
than someone else. It’s the part of perception that you
have the most control over. But many business owners
neglect to take charge of their position in the marketplace
and let customers position their business for them.
How many times have you lowered your prices to get
a new client who balked at your original bid? How many
times have you agreed to provide a certain service to
a client that you never planned to provide, don’t enjoy
doing, and isn’t very profitable? How many times have
you taken on a job that requires the most basic skills you
possess and complained that you can’t get clients that.
Most all of us have been there at some time or another.
Sometimes, it’s important to take on low-end jobs. We all
need to pay the bills. We all experience market downturns.
We all have to build up confidence in our services.
Take a piece of paper and write down 5-10 things you want
people to think of when they think of your business. Here are
several examples, but you might think of many more:
- low price
- fast service
- high quality
- personal service
- caring attitude
- expert advice
- emotional support
- technical expertise
- immediate results
- creative ideas
Now, look through your list and choose the one thing that you
want to emphasize more than any other – the one thing that
will set you apart from your competitors.
Once you have selected it, write down a list of benefits that the
one thing provides to your clients. For example, if you chose
“high quality” from the list above, some benefits might include:
- you make them look good to their employees/employer/clients
- you help projects stay on track because your work is good enough the first time and requires no changes/edits
- you allow them to take one thing completely off their plate because your work meets their standards without their direct involvement
Once you have identified the aspect of your business that you
want to emphasize and you’ve identified the benefits to your
clients, sit down with all of your marketing materials. This
includes your business card, brochure, letterhead, web site,
advertisements, bio sheet, etc. Determine how you can
tweak each one to emphasize this aspect of your business.
The best part about proper positioning is that you end up doing
the type of work you enjoy and making more money. Many
times the work is more profitable because you are able to
charge more than your competitors because you are delivering
more value than they do. The clients that choose to work with
you are making the decision to pay a little more in order to
benefit from the extra value you provide.
Though limited in scope the Profit and Loss Statement provides one of the most valuable financial reports to view your business. The Profit and Loss Statement is the most used business report. Simply stated the Profit and Loss, also commonly referred to as the Income Statement, is a snap shot or balance of money as it flows through your business over a specific period of time, such as a month or a year. The basic formula is revenues minus expenses equals income / profit.
The Profit and Loss breaks out
- revenues or income
- expenses and
- profit or what is left over.
Income Statement / Profit and Loss - Format
A Profit and Loss statement is the easiest way to tell if a business has made a profit or taken a loss over a given period of time. The most important figure referred to is net profit or what is left over after revenues are used to pay expenses and taxes. This figure is normally found in the lower right hand corner at the end of the report. This shows retained earnings or what was left over.
The format a Profit and Loss comes under is known as GAAP – Generally Accepted Accounting Principles. These generally adhere to requirements by government to track income, expenses and profits for tax purposes. A general set of rules allows one to look at the financial reports of two different companies and compare them. Apart from the GAAP there can be a certain amount of creativity allowed in a Profit and Loss Statement. Many of these areas can be ‘tweaked’ to meet management reporting needs. For example, in an income or sales category we can simply state $20,000 in sales or we can break it out into $5,000 catalogue sales and $15,000 in-store sales. The $20,000 sales/income amount remains the same but the breakdown gives management a more accurate picture of where these sales are coming from.
The following are some key points when looking at P& L’s:
- Sales or income is the first category listed. This is simply money taken in.
- Cost of Goods Sold is usually the second item. This relates to all expenses that are directly related to making the item or providing the service. In general this does not include overhead or items that are not directly production/service related.
- Gross Margin or Gross Profit is the next category. This figure subtracts Cost of Goods Sold from Sales. In many industries this figure is extremely important. This figure can tell a business how it is doing in its core business. This Gross Margin/Profit can b
e expressed as a percentage or ratio of sales. Many industries have established norms or benchmarks for where the gross margin percentages or ratios should be. Figures outside these benchmarks usually translate into little or no profit. Since the Gross Margin figure is highly visible in the report, management can quickly see how they are doing. When Gross Margins drop profitability also drops.
- General, Administrative, Selling, Overhead expenses come next. Here also many industries have established figures or ratio benchmarks to show what percentage of sales overhead should be. This can be viewed as what it takes to provide support for the core process of the business.
- The next sections remove 1)interest expenses and 2) taxes.
- Net Income is the last category that shows what is left over after all is said and done. This is sometimes referred to as the ‘final bottom line.’
With the development of accounting software it is much easier to get the types of reports management needs. Here are several additional points that help in viewing these reports:
- Use percentages. This is particularly helpful when tracking trends. Trends may only be fractions of a percentage point shift. Percentages help to detect these shifts.
- It is helpful to have some comparisons. Prior month, same month last year and year-to-date are very common.
- Graphs and tables are extremely helpful when viewing performance over time. We can sometimes see things in a graphic form we cannot see in a report form especially if you are not familiar with accounting. Most accounting software has graph capability.
- Customize your reports to reflect your business information needs. Accountants and bookkeepers are usually competent in what they do but they often do not know your specific needs.
If you do not understand financial reports you should have your accountant or bookkeeper explain them to you. If they cannot explain or won’t explain you should be looking for a new bookkeeper or accountant. It is important to look at other reports as well, especially the balance sheet. Since the Profit and Loss provides only one view of your business it is important to gain greater perspective. For example, one of the common problems I see with P& L’s is they can show a good profit yet the business may be running in part on assets and retained earnings. A quick look at the balance sheet will show asset loss.
Finally think very carefully about the numbers. Superior businesses are seldom run strictly by numbers. On the other hand you will rarely find a superior business that ignores the numbers. Numbers can not only show you how you are doing but flag areas where you need to improve. Especially in a growing business you should carefully monitor your numbers!
There is a simple way to use the information you've gleaned about existing customers to find more profitable ones.
Pareto's Law - also known as the 80/20 rule - can vastly improve your profitability. Very simply, it explains how the significant items in any group normally account for a relatively small proportion of the total. In terms of business, this means that 80% of your sales probably come from 20% of your customers.
When it comes to planning your marketing activity, it's not cost-effective to spread your attentions across your entire customer base - your strategy just wouldn't be effective. It does however; make sense to target specific groups such as the biggest spenders. So before you dive into any marketing campaign, first take some time to identify which of your customers are the most profitable.
Though you can't ignore the rest of your customers, it makes sense to:
- Make a special effort to understand and satisfy the needs of the most profitable group.
- Find more customers with similar profiles to those in your super-group. Here's where it pays to have a detailed and up-to-date database.
If you were selling to businesses, for example, you might want to:
- Categorize your best customers by industry sector, geographical location, turnover, company size, position of the buyer within the company
- Analyze their recent purchasing history with you, including whether they pay on time
- Find what traits are common to the people with purchasing power. What are their buttons? What are their pet hates? What and who influences them?
Having identified these characteristics, you are now in a position to write sales copy, be it for an advertising campaign or a sales letter, precisely targeted, in the right tone and hitting the right hot buttons. You will also be able to identify suitable publications in which to advertise by matching your ideal customer profile to the reader profile.
You also need to know why customers are buying from you. One sales director of a company that builds electronic equipment for the broadcast industry says: "Some customers are buying for a particular reason, which you've got to find out. For example, you might be spending money on developing a very compact model when all the time your best customers couldn't care less about size.
But don't just rely on looking back when you are out to increase sales. Look ahead, too. Keep talking to your existing good customers so you know how their needs are changing. The chances are the needs of your target prospects are changing in a similar way.
In other words, Pareto's Law is fine as a useful general rule, but be aware that you can't just apply an equation to building sales. The world moves on, fashions change and customers look around and move on too - in the direction of your competitors if you don't keep an eye on what new developments are happening in your industry.
And while you focus on the big spenders, don't neglect the rest of your customers and what they might want. Find ways to encourage some of these to move into the top bracket which in turn will change the profile of best customers and product lines.
Just as important as knowing your best customers and attracting more of them is knowing what are your most profitable lines. Apply the same 80/20 rule to the goods you produce or services you offer. Again, analysis will probably reveal that roughly 20% of these generate 80% of all your profits. Once you know this you can market these more effectively to your super-groups of customers and prospects.
However, it can be dangerously simplistic to rate a product or service solely based on volume sold. Something may be selling like hot cakes but actually be costing you a lot in manufacturing terms or involve high delivery, installation and maintenance costs. It may have cost so much to develop that you haven't yet reached break even point. It may be that you are using this as a loss leader to attract buyers for your more profitable lines.
Nothing in business stands still - exchange rates vary, costs rise, competitors cut prices and introduce new models. You need to monitor all these. They are all the more reason to keep your database well fed with the latest information on your customers and to use this information to sell more to them.
Knowledge is only power if, once you've obtained it, you use it to your advantage. And while it may seem like a hassle, remember that it is worth it to find ways to sell more to that magic 20% of customers who generate 80% of your profits.
Income Statement / Profit and Loss - Identifying Problems
The Biggest Problems in Profitability
Rank your firm heirarchically on the following. Put a 10 on the one that causes the most problems in profitability in your own firm, and give a 1 to the one that causes the least problem. You may want to copy this quiz and ask several different partners to give their opinions. Compare the different answers and use them to open a discussion about ways to increase profitability. The higher the score each item gets, the more important it is to take action to improve it.
_____ Not enough new business coming in
_____ Low productivity among associates and staff
_____ Outdated technology
_____ High Write-offs/Low utilization
_____ Unproductive partner(s)
_____ Too many administrative personnel
_____ Inefficient firm administration
_____ High overhead
_____ Weak collections
Take the three top scorers and see if there is a common thread that unites them. Perhaps you need to focus on gaining more clients with year ends in a different season or in a different industry. Or perhaps you need to consolidate several smaller, non-performing offices into one larger centralized location. Or hire a marketing director. Maybe some training in time management or marketing techniques or social skills will resolve the people-related problems.
How you advertise and promote your goods and services may make or break your business. Having a good product or service and not advertising and promoting it is like not having a business at all. Many business owners operate under the mistaken concept that the business will promote itself, and channel money that should be used for advertising and promotions to other areas of the business. Advertising and promotions, however, are the life line of a business and should be treated as such.
Devise a plan that uses advertising and networking as a means to promote your business. Develop short, descriptive copy (text material) that clearly identifies your goods or services, its location and price. Use catchy phrases to arouse the interest of your readers, listeners or viewers. In the case of a franchise, the franchisor will provide advertising and promotional materials as part of the franchise package, you may need approval to use any materials that you and your staff develop. Whether or not this is the case, as a courtesy, allow the franchisor the opportunity to review, comment on and, if required, approve these materials before using them. Make sure the advertisements you create are consistent with the image the franchisor is trying to project. Remember the more care and attention you devote to your marketing program, the more successful your business will be.
Using an Income Statement / Profit and Loss Account
Regularly reviewing your Profit and Loss account, together with your balance sheet and cash book (preferably once a month), allows you to keep an eye on how your business is performing. It can be useful to produce a budget forecast Profit and Loss for each year, and ideally each month, to compare with the actual figures you achieve.
By analysing the differences between your planned and actual Profit and Loss accounts, you can identify what has gone well, such as achieving higher sales, or what hasn't gone so well, such as coping with increased costs. This allows you to identify changes that you need to make and to take corrective action as soon as possible.
Comparing how your business has performed in the current year with the previous year also provides a useful benchmark, and can demonstrate that the business is making good progress.
If you are concerned about excessive overhead charges, it is useful to refer to the Profit and Loss account as it gives a breakdown of each individual type of expense. Remember that loans, loan repayments or any capital introduced by you, as the business owner, is not shown on the Profit and Loss account since it doesn't represent income or expenditure.
If you are unsure about how to draw up a Profit and Loss account, you could seek advice from an accountant or contact a business adviser at your local enterprise agency for support.
Computerized accounting packages will enable you to prepare a Profit and Loss account quickly and easily whenever you need one.
The Financial Plan
Sound financial management is one of the best ways for your business to remain profitable and solvent. How well you manage the finances of your business is the cornerstone of every successful business venture. Each year thousands of potentially successful businesses fail because of poor financial management. As a business owner, you will need to identify and implement policies that will lead to and ensure that you will meet your financial obligations.
To effectively manage your finances, plan a sound, realistic budget by determining the actual amount of money needed to open your business (start-up costs) and the amount needed to keep it open (operating costs). The first step to building a sound financial plan is to devise a start-up budget. Your start-up budget will usually include such one-time-only costs as major equipment, utility deposits, down payments, etc.
The start-up budget should allow for these expenses.
- personnel (costs prior to opening)
- legal/professional fees
- payroll expenses
An operating budget is prepared when you are actually ready to open for business. The operating budget will reflect your priorities in terms of how your spend your money, the expenses you will incur and how you will meet those expenses (income). Your operating budget also should include money to cover the first three to six months of operation. It should allow for the following expenses.
- loan payments
- miscellaneous expenses
- payroll expenses
The financial section of your business plan should include any loan applications you've filed, a capital equipment and supply list, balance sheet, breakeven analysis, pro-forma income projections (profit and loss statement) and pro-forma cash flow. The income statement and cash flow projections should include a three-year summary, detail by month for the first year, and detail by quarter for the second and third years.
The accounting system and the inventory control system that you will be using is generally addressed in this section of the business plan also. If a franchise, the franchisor may stipulate in the franchise contract the type of accounting and inventory systems you may use. If this is the case, he or she should have a system already intact and you will be required to adopt this system. Whether you develop the accounting and inventory systems yourself, have an outside financial advisor develop the systems or the franchisor provides these systems, you will need to acquire a thorough understanding of each segment and how it operates. Your financial advisor can assist you in developing this section of your business plan.
The following questions should help you determine the amount of start-up capital you will need to purchase and open a franchise.
- How much money do you have?
- How much money will you need to purchase the franchise?
- How much money will you need for start-up?
- How much money will you need to stay in business?
- Other questions that you will need to consider are:
- What type of accounting system will your use? Is it a single entry or dual entry system?
- What will your sales goals and profit goals for the coming year be? If a franchise, will the franchisor set your sales and profit goals? Or, will he or she expect you to reach and retain a certain sales level and profit margin?
- What financial projections will you need to include in your business plan?
- What kind of inventory control system will you use?
Your plan should include an explanation of all projections. Unless you are thoroughly familiar with financial statements, get help in preparing your cash flow and income statements and your balance sheet. Your aim is not to become a financial wizard, but to understand the financial tools well enough to gain their benefits. Your accountant or financial advisor can help you accomplish this goal.
A strong Business Plan may not guarantee success; but it could certainly prevent failure!
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